How to Test and Interpret Trading System Performance
by Wayne A. Thorp, CFA
Pick up any technical analysis trade magazine, and inevitably you will run across companies and practitioners marketing technical analysis trading systems. Like any other type of investment strategy or methodology, a popular way to determine how one system stacks up against another is by comparing annual returns. While these numbers are helpful in separating the winners from the losers, it is important to keep in mind that a multitude of factors impacts the performance of any trading system.
When judging the efficacy of a system’s reported performance or the performance of a system you create, keep in mind several issues:
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- Are the performance figures based on backtesting or actual trading?
- Is the system optimized and, if so, how does it perform over “hold-out” periods?
- How does it handle income reinvestment?
- Are there any tax implications?
- What are the assumptions inherent to the system itself—commissions, slippage, and money and risk management stops?
This article will walk you through a general discussion of how these elements can impact the financial performance of a trading system.
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