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Have you ever seen a trading system published in a book or on a website or somewhere, and in fine print down the bottom it says, “Results exclude slippage and commission”? If you’ve seen that and you’ve ignored it, now’s the time to stop because this is one of my biggest bugbears about the trading industry. It’s super easy to develop an amazing trading system that performs super well in a backtest if you exclude slippage and commissions. But the fact is, slippage and commissions are a part of trading life and you cannot escape it.
One thing that I’ve noticed, particularly in a lot of trading system books is that huge numbers of authors publish short-term trading systems excluding slippage and commissions. The reason they do that is because when you add slippage and commissions in, most of those short-term trading systems look completely rubbish and the backtest results degrade significantly often to the point of being un-tradable. If you’re backtesting and you are excluding slippage and commissions, you’ve got to change your habits and you’ve got to start being a bit more realistic about the way you evaluate your trading results.
Why backtesting trading systems with slippage and commissions is critical
Early on in my backtesting process when I’m working with students in the Trader Success System, I encourage them to test with slippage and commissions to make sure that the edge the system generates is big enough to be actually profitable in the real world. If you don’t do that, you’re just deluding yourself. Whether you’re using Amibroker or any other trading software in your backtest, you’ve got to add slippage and commissions to get a true sense for how profitable your system will be in the real world once all trading costs are considered.
Don’t forget, it’s not just the brokerage. For instance, if you’re trading small cap stocks, you’ve really got to account for some extra slippage in your backtest results because often when you get in and get out of small cap stocks, you’re going to move the market just a little bit, and so slippage is a real thing. In ultra liquid contracts or many future contracts, slippage is much less of an issue, but you’ve still got to think about it depending on what your trading strategy is.
If you have not backtested your trading results and trading system with slippage and commissions, stop what you’re doing, go to your trading software, crack it open, add some slippage and commissions, and increase that slippage and commissions amount to more than what you’re actually paying in the market now. What I like to do is step my slippage and commissions up gradually and see when the system breaks. If the system remains profitable well beyond where slippage and commissions are likely to be, then that gives me a high sense of confidence. Make sure you’re taking this into account in your trading system.
Conclusion on slippage and commissions in your trading systems
Always remember, if you haven’t, backtested your trading system, then that’s the number one thing you’ve got to do. You don’t even have a clue what the profitability of your system is going to be until you backtest it. There’s several other things that you need to do to build confidence in your trading system, so click the link below and download my trading system confidence cheat sheet, to make sure that you’ve ticked off all 11 steps that I take every time I develop and launch a new trading system, to make sure I’ve got rock solid confidence that that system will work in real-world trading.