PWB#1: Forgetting About The Spread

[PWB = Problem With Backtesting]

Yes, yes, forgetting about the spread (in currency trading, or forgetting about the commission for traders of other things). Essentially, forgetting about any miscellanous costs of trading.

Simply, if you can make $5 each and every time you trade, you'd become rich very quickly. Unless... it costs you $10 in spread/commission/other each and every time you trade. And sometimes people forget that $10 in spread/commission/other bit.

Here's an example. A while ago I thought I'd stumbled onto the world's most simplest yet profitable trading system. I couldn't believe others hadn't thought of it. I was giddy with excitement.

The system I thought of, on the 5 minute chart, was to set a long entry order at the high of the last 5 bars, with stop loss at the low of the last 5 bars. Each bar move the stop loss to the low of the last 5 bars. Eventually, hopefully, the low of the last 5 bars would rise above the initial entry point, and I'd make a profit. Reverse for shorts.

You are laughing because that's a simple breakout system, and it's been around since the dawn of trading. I know that too... now.

Anyway, I was looking at the EURUSD 5 minute chart of the bid (in Oanda's charts you can chart the bid or ask or the average), and "backtested" over about 2 days worth of data. The end result was faaaantastic: 112 pips profit. 112 pips in that short time! If you trade 1 contract and make 112 pips profit, that equals US$1120. All I could see were dollar signs.

80 trades were executed in those 2 days. The problem I had with the fantastic system that I'd "created" was that I wouldn't have been able to sleep - the system required constant attention as it traded so often. (Hmmm, might need a trading-bot to help me out, I might have thought at the time :-)

And the other problem was that I'd forgotten all about the spread. The prices I worked off were all bid prices. Take the spread into account - 1.5 pips at Oanda times 80 trades = 120 pips. 112 pips profit minus 120 pips spread = -8 pips.

Excitement giddiness... fading...