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No pain, no gain: You should always incorporate trading costs for a bias-free evaluation of trading rule overperformance

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  • Anghel, Dan Gabriel

Abstract

In their search for better-performing trading rules (forecasting models), traders and researchers always engage in some form of data snooping. In the current context of extensive data snooping efforts, we show that accounting for both transaction fees and liquidity costs is crucial for controlling data snooping bias. Specifically, we document that even state-of-the-art, conservative multiple testing procedures (MTPs) have significant size distortions when either is missing from the loss function that describes trading (over)performance. This result is not obvious as, in theory, MTP results should not depend on how the loss function is specified. However, empirical realities differ from theory in a way that requires traders and researchers to directly consider trading costs when looking to adequately control false discoveries.

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  • Anghel, Dan Gabriel, 2022. "No pain, no gain: You should always incorporate trading costs for a bias-free evaluation of trading rule overperformance," Economics Letters, Elsevier, vol. 216(C).
    • Handle: RePEc:eee:ecolet:v:216:y:2022:i:c:s0165176522001720
    DOI: 10.1016/j.econlet.2022.110584
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    References listed on IDEAS

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    More about this item

    Keywords

    Trading rules; Forecasting models; Trading costs; Data snooping; Multiple testing procedures; False discoveries;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C18 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Methodolical Issues: General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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