By Leo Zamansky, President, RINA Systems*
Posted: Jun 5, 2009
Portfolio testing is a method of testing a particular strategy (or group of strategies) on a portfolio of symbols, thereby, generating a performance report for that portfolio. Portfolio testing simulates the trading process when trading decisions on one symbol depend on the amount of portfolio equity, which is determined by the trades and positions for all symbols. Results produced via portfolio testing differ significantly when compared with performance from testing on an individual symbol.
Portfolio trading offers numerous benefits -- from trading in a variety of markets, to achieving consistency of returns to having the ability to re-allocate capital among various symbols. When trading a portfolio of symbols, traders typically use various position sizing (money management) strategies based on portfolio equity.
Here are a few examples of portfolio testing techniques:
- Futures traders can specify X% of the portfolio equity in each trade to buy as many contracts as possible based on margin requirements. An example would be: For a $1,000,000 account, trading 1% of the portfolio equity to buy ES with a margin of $4,000, leading to the purchase of 2 contracts.
- Equities traders may wish to rank all the symbols in a portfolio to determine the best or worst performing symbols before applying a strategy to the selected group.
- Traders can apply constraints to strategies to test some of the conditions put by brokers or investors, such as the condition that dictates that margin-to-equity ratio should not exceed 35%.
Another concept employed by traders is to exit all positions if the portfolio reaches a pre-determined amount of profit or loss during a given period and wait until the start of the next period. This technique is called "equity filter", also known as "portfolio stop".
Portfolio testing is an important step in strategy development that allows for both controlling risk and increasing returns.
*Reprinted (and modified) with permission from Leo Zamansky