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1 RHEINISCH-WESTFÄLISCHE TECHNISCHE HOCHSCHULE AACHEN Institut für Mathematik Backtest of trading systems on candle charts by S. Maier-Paape A. Platen Report No January 2015 Institute for Mathematics, RWTH Aachen University Templergraben 55, D Aachen Germany

4 BACKTEST OF TRADING SYSTEMS ON CANDLE CHARTS 3 at the beginning of the period the decisions for such an active position in succeeding bars is simpler. The decision tree for the latter is given in Subsection 2.5. We close the discussion with the conclusion in Section 3. 2 Backtest evaluation algorithm We look at situations for different entry and setups. All orders are generated at the end of a candle so that these orders can be filled in the next candle. Therefore we take a look at this next candle for different orders. The examined candle has the four values H = High, L = Low, O = Open and C = Close. 2.1 Assumptions and limitations In order to be able to perform exact calculations we first need to make a continuity assumption on the price evolution within a candle. Assumption 1. (No intra-period gaps) We assume that the price evolution inside the period skips no nearby tick-values, i.e. starting at the open until the end of the period at the close all price moves during that period (up or down) come only as ± 1 tick. Intra-period gaps, i.e. moves by more than one tick, thus are not allowed. This assumptions is essential for determining intra-period entry or prices, e.g. at limit or stop levels. In live trading, however, this assumption is not realistic. To overcome this problem usually slippage is introduced for each backtest trade, see e.g. the book of Pardo [10, Chapter 6, Section Realistic Assumptions ] for a detailed discussion. Additionally we need to assume that all orders are filled at the requested price. Assumption 2. (Market liquidity) We assume that we trade on a perfectly liquid market. I.e. our orders do not affect the price changes and are fully filled at the corresponding entry or stop level. Of course this assumption is also not realistic. Similar to Assumption 1 slippage can help to get more reasonable results. Since all prices (measured as tick-values) are integers we need to make sure that all values given by the user (like limit level, etc.) are of the same type to avoid rounding errors, see also [10, Chapter 6, Section Software Limitations ]. Assumption 3. (Rounded values) All values like limit price, target and stop loss level are given as numbers which are rounded to the corresponding next possible price value which depends on the tick size. For long positions the stop level for stop order and the target level are rounded up while the stop loss level and limit price are rounded down. For short positions the stop level for stop order and the target level are then rounded down while the stop loss level and limit price needs to be rounded up. This way to round the values does not change any decision during the backtest evaluation but it corrects the price values used for the computation of the outcomes of each trade. In case the long position is coupled with a stop loss order (stop level ) or a target order (target level ) we always assume < < and < <.

5 4 S. MAIER-PAAPE, AND A. PLATEN Next we need to make some simplification for the best and worst case for SNUs. Suppose we are invested in a stock and there is a SNU with the two options of the position at target level or to stay invested. Of course at should immediately lead to a win trade. However, if we change the target in the next period it is possible to earn even more money if we do not the position at this moment but later in one of the subsequent candles. This can also affect upcoming trades which in general depend on the current status (invested or not invested) and thus can increase the comply of the decisions needed to be done for the real (globally) best case. Therefore we always choose the simplest setting which is best for the user at the current period. In this easy example this would be to immediately the position at target level. Assumption 4. (Worst and best case) Best and worst case decisions in situations which cannot be uniquely determined (SNU) should be made on premise that it is best/worst for the current period only. 2.2 Entry of a long position with limit order Here the long position is only opened, once the price reaches the limit level (or below). This is the situation of an entry with the classical EnterLongLimit() order optionally supplemented by stop loss and target levels. We assume < <. The decision trees are shown in Figures 1 to 3. limit at L > do not L at min{o, } L > limit at do not stop loss at < L at min{o, } L > do not L at min{o, } (a) Only limit long order. (b) Limit long order supplemented with stop loss. Figure 1: Entry setups with limit long order. L > limit at do not < L l at min{o, } H H < do not O at O > A C < is not determinable wc: do not bc: at C at Figure 2: Entry setup with limit long order supplemented with target.

6 BACKTEST OF TRADING SYSTEMS ON CANDLE CHARTS 5 limit at stop loss at < < H < without target H L at min{o, } L > without stop B O O > at or wc: at bc: at at O Figure 3: Entry setup with limit long order supplemented with stop loss and target. A B (a) Cases for Figure 2. (b) Cases for Figure 3. Figure 4: Variations of possible price development within a candle for SNU with limit long order. In Figures 2 and 3 the cases marked with A and B, respectively, are two SNUs, i.e. if we cannot load extra data like tick data to make these situations unique, there are multiple possibilities for the correct position entry and/or. Figure 4 shows one example for each possibility for both SNUs A and B. We always assume < because of the following reason: In case the position would be closed right after it is opened, which makes no sense and should therefore be forbidden by the software, i.e. these order should be canceled/ignored. If the same would happen if O and of course L. However, if O < the position would be opened at the beginning of the period which is equivalent to a market order executed at the open of the subsequent period. In this case the trade would not immediately be stopped and thus can be handled as in Subsection 2.5 if it is not ignored in advance. From the decision trees in Figures 1 to 3 we see that for limit orders only a combination involving a target where the target is reached in the entry period leads to SNUs. If there is no target or if the target is far away all situations are uniquely decidable. 2.3 Entry of a long position with stop order Here the long position is only opened, once the price reaches the stop level (or above), created by the classical EnterLongStop() order. Again the order can optionally be supplemented by stop loss ( ) and target levels ( ) with < <. The decision trees are shown in Figures 5 to 7 and the examples for the SNUs in Figure 8.

7 6 S. MAIER-PAAPE, AND A. PLATEN stop at H < do not H at max{o, } H < stop at do not < H at max{o, } H < do not H at max{o, } (a) Only stop long order. (b) Stop long order supplemented with target. Figure 5: Entry setups with stop long order. H < stop at do not stop loss at < H b at max{o, } L L > do not O at O < C C C > is not determinable wc: at bc: do not at Figure 6: Entry setup with stop long order supplemented with stop loss. stop at stop loss at < < H < without target H L at max{o, } L > without stop D O O at O < at or wc: at bc: at Figure 7: Entry setup with stop long order supplemented with stop loss and target. C D (a) Cases for Figure 6. (b) Cases for Figure 7. Figure 8: Variations of possible price development within a candle for SNU with stop long order.

8 BACKTEST OF TRADING SYSTEMS ON CANDLE CHARTS 7 Since an entry stop order is some kind of mirrored version of the entry limit order, we now have SNUs for the entry stop order supplemented with an initial stop loss level. Again, the case makes no sense, because the position would be closed immediately after the opening, compare the case for long limit order. In the case the position is either to be closed after opening if O or, if O >, we have an equivalent case to a market order. 2.4 Entry of a long position with stop limit order Here a limit order at level is only generated, once the price reaches the stop level (or above), as is generated by the classical EnterLongStopLimit() order. I.e. the trader in principle wishes to have an EnterLongLimit() order at level, but to activate that order he firstly wants that the prices reach the stop level (or higher). Again this order may optionally be supplemented by stop loss ( ) or target levels ( ). We assume < min{, } <. The decision trees are shown in Figures 9 to 12, and examples for the SNUs in Figures 13 to 16, respectively. stop limit at and H < do not H limit order at is active O < activation of at limit order intra period > O limit at E C > entry is not determinable wc: no entry bc: at L > do not, but limit order at for next period L C at Figure 9: Entry setup with stop limit long order. This entry order type is much more complex and therefore leads to larger decision trees and much more SNUs. Even the worst cases and/or best cases for some SNUs are not uniquely determinable because there are situations where a position can be opened or there is just an active limit order at the end of the candle, see e.g. SNU E. In general it is not clear whether it is worst or best to have an active limit order or an open position at the end of the candle in such cases. Because of Assumption 4 we decide to measure the quality of an open trade by the current value of the trade which in this case is the difference between the close of the candle and the entry price of the position. If the close is larger than the entry price we currently are in a positive trade (and thus the best case) which is better than having just an active limit order (worst case), and vice versa if the close is below the entry price.

9 8 S. MAIER-PAAPE, AND A. PLATEN C at min{, } at F < C stop limit at and stop loss at < min{, } L > without stop L H limit order at is active H < do nothing O < activation of limit order intra period O limit at and stop loss at at min{, } is not determinable wc: at bc: no C > G < entry is not determinable wc: at at bc: at no H at is not determinable wc: at bc: no Figure 10: Entry setup with stop limit long order supplemented with stop loss. stop limit at and H < without target H limit order at is active > H H < do nothing O limit at and O < activation of limit order intra period L > limit order at and for next period L > entry is not determinable at at I C J < C < K open position at the end of the period is possible wc: at bc: at at open position at the end of the period is possible wc: limit order at and target at for next period bc: at at C no open position at the end of the period wc: limit order at and target at for next period bc: at at Figure 11: Entry setup with stop limit long order supplemented with target.

10 BACKTEST OF TRADING SYSTEMS ON CANDLE CHARTS 9 stop limit at and stop loss at < < H < without target L and H < L > s without stop H limit order at is active H < do nothing O limit at, stop loss at and O < activation of limit order intra period L at is not determinable (no open position at the end of the period) wc: at bc: at > M C > entry is not determinable wc: at at bc: at at N C at is not determinable (open position at the end of the period is possible, if < C) wc: at bc: at Figure 12: Entry setup with stop limit long order supplemented with stop loss and target. E Figure 13: Variations of possible price development within a candle for SNU with stop limit long order for Figure 9. F G H Figure 14: Variations of possible price development within a candle for SNU with stop limit long order for Figure 10.

11 10 S. MAIER-PAAPE, AND A. PLATEN I J K Figure 15: Variations of possible price development within a candle for SNU with stop limit long order for Figure 11. L M N Figure 16: Variations of possible price development within a candle for SNU with stop limit long order for Figure Exit from an active long position The final discussion deals with the case of an active long position, i.e. at the end of the prior period a long position remained open. This also includes situations where a market order was generated in the prior candle such that a long position is opened right at the open of the current period. The decision trees for the current period are shown in Figures 17 and 18 and the examples for the SNUs in Figure 19. stop loss at L > do not L at min{o, } H at max{o, } H < do not (a) Only stop loss. (b) Only target. Figure 17: Exit setups during an active long position.

12 BACKTEST OF TRADING SYSTEMS ON CANDLE CHARTS 11 L > at H O L O at O stop loss at < < O < O at O at or wc: at bc: at ig: ignore whole trade L > do not H < L at Figure 18: Exit setup during an active long position with both, stop loss and target. O Figure 19: Variations of possible price development within a candle for SNU during an active long position for Figure Conclusions The precise listing of the backtest evaluation algorithm in the preceding section shows very clearly that not uniquely decidable situations (SNUs) are omnipresent when only candle data are available. This is not consistent with the fact that wide spread software solutions ignore that problem completely. An honest evaluation should give users the choice of worst/best case calculations. Future software solutions should be able to reload finer candle or tick data for the bars in question in order to evaluate backtests exactly. References [1] Bailey, D. H., J. M. Borwein, M. L. de Prado and Q. J. Zhu: The Probability of Backtest Overfitting. Available at SSRN, DOI: /ssrn , [2] Bailey, D. H., J. M. Borwein, M. L. de Prado and Q. J. Zhu: Pseudo-Mathematics and Financial Charlatanism: The Effects of Backtest Overfitting on Out-of-Sample Performance. Notices of the AMS, 61(5): , /rnoti-p458.pdf. [3] Carr, P. P. and M. L. de Prado: Determining Optimal Trading Rules without Backtesting. arxiv: [q-fin.pm], 2014.

14 Reports des Instituts für Mathematik der RWTH Aachen [1] Bemelmans J.: Die Vorlesung Figur und Rotation der Himmelskörper von F. Hausdorff, WS 1895/96, Universität Leipzig, S 20, März 2005 [2] Wagner A.: Optimal Shape Problems for Eigenvalues, S 30, März 2005 [3] Hildebrandt S. and von der Mosel H.: Conformal representation of surfaces, and Plateau s problem for Cartan functionals, S 43, Juli 2005 [4] Reiter P.: All curves in a C 1 -neighbourhood of a given embedded curve are isotopic, S 8, Oktober 2005 [5] Maier-Paape S., Mischaikow K. and Wanner T.: Structure of the Attractor of the Cahn-Hilliard Equation, S 68, Oktober 2005 [6] Strzelecki P. and von der Mosel H.: On rectifiable curves with L p bounds on global curvature: Self avoidance, regularity, and minimizing knots, S 35, Dezember 2005 [7] Bandle C. and Wagner A.: Optimization problems for weighted Sobolev constants, S 23, Dezember 2005 [8] Bandle C. and Wagner A.: Sobolev Constants in Disconnected Domains, S 9, Januar 2006 [9] McKenna P.J. and Reichel W.: A priori bounds for semilinear equations and a new class of critical exponents for Lipschitz domains, S 25, Mai 2006 [10] Bandle C., Below J. v. and Reichel W.: Positivity and anti-maximum principles for elliptic operators with mixed boundary conditions, S 32, Mai 2006 [11] Kyed M.: Travelling Wave Solutions of the Heat Equation in Three Dimensional Cylinders with Non-Linear Dissipation on the Boundary, S 24, Juli 2006 [12] Blatt S. and Reiter P.: Does Finite Knot Energy Lead To Differentiability?, S 30, September 2006 [13] Grunau H.-C., Ould Ahmedou M. and Reichel W.: The Paneitz equation in hyperbolic space, S 22, September 2006 [14] Maier-Paape S., Miller U.,Mischaikow K. and Wanner T.: Rigorous Numerics for the Cahn-Hilliard Equation on the Unit Square, S 67, Oktober 2006 [15] von der Mosel H. and Winklmann S.: On weakly harmonic maps from Finsler to Riemannian manifolds, S 43, November 2006 [16] Hildebrandt S., Maddocks J. H. and von der Mosel H.: Obstacle problems for elastic rods, S 21, Januar 2007 [17] Galdi P. Giovanni: Some Mathematical Properties of the Steady-State Navier-Stokes Problem Past a Three- Dimensional Obstacle, S 86, Mai 2007 [18] Winter N.: W 2,p and W 1,p -estimates at the boundary for solutions of fully nonlinear, uniformly elliptic equations, S 34, Juli 2007 [19] Strzelecki P., Szumańska M. and von der Mosel H.: A geometric curvature double integral of Menger type for space curves, S 20, September 2007 [20] Bandle C. and Wagner A.: Optimization problems for an energy functional with mass constraint revisited, S 20, März 2008 [21] Reiter P., Felix D., von der Mosel H. and Alt W.: Energetics and dynamics of global integrals modeling interaction between stiff filaments, S 38, April 2008 [22] Belloni M. and Wagner A.: The Eigenvalue Problem from a Variational Point of View, S 18, Mai 2008 [23] Galdi P. Giovanni and Kyed M.: Steady Flow of a Navier-Stokes Liquid Past an Elastic Body, S 28, Mai 2008 [24] Hildebrandt S. and von der Mosel H.: Conformal mapping of multiply connected Riemann domains by a variational approach, S 50, Juli 2008 [25] Blatt S.: On the Blow-Up Limit for the Radially Symmetric Willmore Flow, S 23, Juli 2008 [26] Müller F. and Schikorra A.: Boundary regularity via Uhlenbeck-Rivière decomposition, S 20, Juli 2008 [27] Blatt S.: A Lower Bound for the Gromov Distortion of Knotted Submanifolds, S 26, August 2008 [28] Blatt S.: Chord-Arc Constants for Submanifolds of Arbitrary Codimension, S 35, November 2008 [29] Strzelecki P., Szumańska M. and von der Mosel H.: Regularizing and self-avoidance effects of integral Menger curvature, S 33, November 2008 [30] Gerlach H. and von der Mosel H.: Yin-Yang-Kurven lösen ein Packungsproblem, S 4, Dezember 2008 [31] Buttazzo G. and Wagner A.: On some Rescaled Shape Optimization Problems, S 17, März 2009 [32] Gerlach H. and von der Mosel H.: What are the longest ropes on the unit sphere?, S 50, März 2009 [33] Schikorra A.: A Remark on Gauge Transformations and the Moving Frame Method, S 17, Juni 2009 [34] Blatt S.: Note on Continuously Differentiable Isotopies, S 18, August 2009 [35] Knappmann K.: Die zweite Gebietsvariation für die gebeulte Platte, S 29, Oktober 2009 [36] Strzelecki P. and von der Mosel H.: Integral Menger curvature for surfaces, S 64, November 2009 [37] Maier-Paape S., Imkeller P.: Investor Psychology Models, S 30, November 2009 [38] Scholtes S.: Elastic Catenoids, S 23, Dezember 2009 [39] Bemelmans J., Galdi G.P. and Kyed M.: On the Steady Motion of an Elastic Body Moving Freely in a Navier-Stokes Liquid under the Action of a Constant Body Force, S 67, Dezember 2009 [40] Galdi G.P. and Kyed M.: Steady-State Navier-Stokes Flows Past a Rotating Body: Leray Solutions are Physically Reasonable, S 25, Dezember 2009

15 [41] Galdi G.P. and Kyed M.: Steady-State Navier-Stokes Flows Around a Rotating Body: Leray Solutions are Physically Reasonable, S 15, Dezember 2009 [42] Bemelmans J., Galdi G.P. and Kyed M.: Fluid Flows Around Floating Bodies, I: The Hydrostatic Case, S 19, Dezember 2009 [43] Schikorra A.: Regularity of n/2-harmonic maps into spheres, S 91, März 2010 [44] Gerlach H. and von der Mosel H.: On sphere-filling ropes, S 15, März 2010 [45] Strzelecki P. and von der Mosel H.: Tangent-point self-avoidance energies for curves, S 23, Juni 2010 [46] Schikorra A.: Regularity of n/2-harmonic maps into spheres (short), S 36, Juni 2010 [47] Schikorra A.: A Note on Regularity for the n-dimensional H-System assuming logarithmic higher Integrability, S 30, Dezember 2010 [48] Bemelmans J.: Über die Integration der Parabel, die Entdeckung der Kegelschnitte und die Parabel als literarische Figur, S 14, Januar 2011 [49] Strzelecki P. and von der Mosel H.: Tangent-point repulsive potentials for a class of non-smooth m-dimensional sets in R n. Part I: Smoothing and self-avoidance effects, S 47, Februar 2011 [50] Scholtes S.: For which positive p is the integral Menger curvature M p finite for all simple polygons, S 9, November 2011 [51] Bemelmans J., Galdi G. P. and Kyed M.: Fluid Flows Around Rigid Bodies, I: The Hydrostatic Case, S 32, Dezember 2011 [52] Scholtes S.: Tangency properties of sets with finite geometric curvature energies, S 39, Februar 2012 [53] Scholtes S.: A characterisation of inner product spaces by the maximal circumradius of spheres, S 8, Februar 2012 [54] Kolasiński S., Strzelecki P. and von der Mosel H.: Characterizing W 2,p submanifolds by p-integrability of global curvatures, S 44, März 2012 [55] Bemelmans J., Galdi G.P. and Kyed M.: On the Steady Motion of a Coupled System Solid-Liquid, S 95, April 2012 [56] Deipenbrock M.: On the existence of a drag minimizing shape in an incompressible fluid, S 23, Mai 2012 [57] Strzelecki P., Szumańska M. and von der Mosel H.: On some knot energies involving Menger curvature, S 30, September 2012 [58] Overath P. and von der Mosel H.: Plateau s problem in Finsler 3-space, S 42, September 2012 [59] Strzelecki P. and von der Mosel H.: Menger curvature as a knot energy, S 41, Januar 2013 [60] Strzelecki P. and von der Mosel H.: How averaged Menger curvatures control regularity and topology of curves and surfaces, S 13, Februar 2013 [61] Hafizogullari Y., Maier-Paape S. and Platen A.: Empirical Study of the Trend Indicator, S 25, April 2013 [62] Scholtes S.: On hypersurfaces of positive reach, alternating Steiner formulæ and Hadwiger s Problem, S 22, April 2013 [63] Bemelmans J., Galdi G.P. and Kyed M.: Capillary surfaces and floating bodies, S 16, Mai 2013 [64] Bandle, C. and Wagner A.: Domain derivatives for energy functionals with boundary integrals; optimality and monotonicity., S 13, Mai 2013 [65] Bandle, C. and Wagner A.: Second variation of domain functionals and applications to problems with Robin boundary conditions, S 33, Mai 2013 [66] Maier-Paape, S.: Optimal f and diversification, S 7, Oktober 2013 [67] Maier-Paape, S.: Existence theorems for optimal fractional trading, S 9, Oktober 2013 [68] Scholtes, S.: Discrete Möbius Energy, S 11, November 2013 [69] Bemelmans, J.: Optimale Kurven über die Anfänge der Variationsrechnung, S 22, Dezember 2013 [70] Scholtes, S.: Discrete Thickness, S 12, Februar 2014 [71] Bandle, C. and Wagner A.: Isoperimetric inequalities for the principal eigenvalue of a membrane and the energy of problems with Robin boundary conditions., S 12, März 2014 [72] Overath P. and von der Mosel H.: On minimal immersions in Finsler space., S 26, April 2014 [73] Bandle, C. and Wagner A.: Two Robin boundary value problems with opposite sign., S 17, Juni 2014 [74] Knappmann, K. and Wagner A.: Optimality conditions for the buckling of a clamped plate., S 23, September 2014 [75] Bemelmans, J.: Über den Einfluß der mathematischen Beschreibung physikalischer Phänomene auf die Reine Mathematik und die These von Wigner, S 23, September 2014 [76] Havenith, T. and Scholtes, S.: Comparing maximal mean values on different scales, S 4, Januar 2015 [77] Maier-Paape, S. and Platen, A.: Backtest of trading systems on candle charts, S 12, Januar 2015

### arxiv:1412.5558v1 [q-fin.tr] 17 Dec 2014

Backtest of Trading Systems on Candle Charts Stanislaus Maier-Paape Institut für Mathematik, RWTH Aachen, Templergraben 55, D-52052 Aachen, Germany maier@instmath.rwth-aachen.de Andreas Platen Institut

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