Constant Position Sizing of Spreads Revisited (Part 2)

I’m doing a Part 2 because early this morning, I had another flash of confusion about the meaning of “homogeneous backtest.”

The confusion originated from my current trading approach. Despite my backtesting, I still trade with a fixed credit. If I used a fixed delta then 2x-5x initial credit (stop loss) would be larger at higher underlying prices. Gross drawdown as a percentage of the initial account value would consequently be higher. This means drawdown percentage could not be compared on an apples-to-apples basis across the entire backtesting interval.

Read the “with regard to backtesting” paragraph under the graph shown here. Constant position size (e.g. number of contracts or notional value?), apples-to-apples comparison of PnL changes (e.g. gross or percentage of initial/current account value?) throughout, and evaluating any drawdown (e.g. gross or as a percentage of initial/current account value?) as if it happened from Day 1 are all nebulous and potentially contradictory references (as described).

In this post, I argue:

     > Sticking with the conservative theme, I should also calculate
     > DD as a percentage of initial equity because this will give a
     > larger DD value and a smaller position size. For a backtest
     > from 2001-2015, 2008 was horrific but as a percentage of
     > total equity it might not look so bad if the system had
     > doubled initial equity up to that point.

If I trade fixed credit then I am less likely to incur drawdown altogether at higher underlying price, which makes for a heterogeneous backtest when looking at the entire sample of daily trades. If I trade fixed delta then see the last sentence of (above) paragraph #2.

I focused the discussion on position size in this 2016 post where I stressed constant number of contracts. Recent discussion has neither focused on fixed contracts nor fixed credit.

“Things” seem to “get screwed up” (intentionally nebulous) if I attempt to normalize to allow for an apples-to-apples comparison of any drawdown as if it occurred from Day 1.

If I allow spread width [if backtesting a spread] to vary with underlying price and I sell a fixed delta—as discussed in Part 1—then a better solution may be to calculate gross drawdowns as a percentage of the highwater account value to date. I will leave this to simmer until my next blogging session for review.

I was going to end with one further point but I think this post has been sufficiently thick to leave it here. I will conclude with Part 3 of this blogging detour next year!