there is a substantial difference between the healthy system and a tradable system:

- healthy (statistically & mathematically sound) system is able to uncover some price behavior inefficiency and generate trades that deliver consistent non-zero outcome with no trade costs involved
- tradable system is a combination of a healthy system and a specific market (specific trade costs, volatility, liquidity) which delivers a positive outcome

If you come up with a healthy system that uncovers some market inefficiency (like buying the exact bottoms and selling the exact tops ), then it's splendid. But now imagine the market you will trade this system on will be a non-volatile, non-liquid market with tiny swings and feeble vitality in general.

Yes, you will be able to catch all the swings perfectly, so the mathematics behind your idea works correctly and the little nerdy scientist inside you claps his hands

But given the fact that the average swing would be too minute to cover the spread/commissions (to say nothing of the ugly slippage in stocks if the market is not liquid enough), the hard-headed investment manager inside you sets in and informs the little nerdy scientist that the system is an overall loser. (well actually, there might be a number of persons inside you expressing their opinions on the issue. If this is the case, I recommend go and see your shrink)

Healthy is not always tradable

What's the morals of the above example?

- You might have a healthy system (does it catch all the swings correctly? Yes)
- This healthy system is not necessarily a tradable system when combined with the particular market (is the outcome of applying this healthy system to a specific market with all the costs involved positive? No)

Fighting the randomness

Now let's focus on my initial definition of the healthy system:

- healthy (statistically & mathematically sound) system is able to uncover some price behavior inefficiency and generate trades that deliver consistent non-zero outcome with no trade costs involved

If you come up with a trading system and its equity curve goes nose down with the trading costs involved, you actually can't assess whether it is a healthy system or not.

It might still be a healthy system.

Why?

Because the trading costs distort the assessment at this stage of development. Remember, the trading costs apply to a specific market only and have nothing to do with the trading model logic itself.

If the trading model generates consistent non-zero outcome without the trading costs involved, then it doesn't matter whether the outcome is positive or negative. You may easily switch between the negative and positive outcome by simply reversing the trade logic.

But if there are trading costs involved, you don't know wheter the nose-down equity curve is a consequence of a desirable healthy model that generates consistent non-zero (in this case negative) outcome or a miserable not healthy model that generates random trades (random = zero in the long run) and the non-zero behaviour is only a result of subtracting the trade costs.

A textbook example

To illustrate, let's have two trading systems:

- SwingSystem 01 (a healthy system of yours)
- SwingSystem 02 (a not healthy system of your neighbor )

- Market A (trade costs = $10 a trade)
- Market B (trade costs = $60 a trade)

- direction 1 (go long when long signalled, go short when short signalled)
- direction -1 (go short when long signalled, go long when short signalled)

The healthy SwingSystem 01 is able to deliver a consistent non-zero outcome with no costs involved and it does not matter whether the outcome is positive or negative as long as it is non-zero (non-random):

On the other hand, our poor neighbor's not healthy SwingSystem 02 generates random trades (zero outcome in the long run) and he can't make it better even if he switches the direction from 1 to -1 since randomness (or zero) is not polarized, there is no directional trend (it always ends up yielding zero):

Now let's apply our good, healthy SwingSystem to Market A and Market B with direction 1:

Obviously, the healthy SwingSystem 01 lives up to the expectations to make up for a tradable system only at the Market A, where the trading costs are $10 per trade. Market B features $60 trading costs per trade, which makes the combination of this healthy system and this market untradable.

We now know our SwingSystem 01 produces a positive tradable outcome for a direction = 1 (above left), so, naturally, reversing the trade logic to direction = -1 would make no sense for SwingSystem 01:

Now whatever the Market and whatever the direction, the not healthy system always produces a negative outcome. This non-zero outcome is caused by an inclusion of the trading costs (always a negative tendency), not by a desired ability of the system to produce a non-zero outcome. This is the prinicipal reason why the assessment whether the system is healthy or not cannot be done with the trading costs involved. Random SwingSystem 02 with trading costs accross two markets and the opposite directions:

Conclusion

The only way to capitalize on price behavior inefficiency is to find a set of rules that produces a series of non-random observations. It's irrelevant whether the observations (the trades) have a negative tendency or a positive tendency.

Since including the trading costs in a trading outcomes calculations always adds a negative tendency to the original string of non-biased observations, it is essential to not include the trading costs in this stage of trading system development.

If this rule is neglected, the trading system developer is not able to tell whether the non-random behavior with non-zero outcome is caused by a sound set of rules or simply by a negative tendency that has been falsely implanted into the series of observations by adding the trading costs.

Have a very nice day, friends!

Michal

Attached: the source excel table with graph