Monday, October 29, 2012

Part 2 "Back Testing Theory"

MetaStock SPRS Series - Week 92 - TechniTrader® Stock Discussion for MetaStock Users - Part 2 "Back Testing Theory" - October 29, 2012
By: Martha Stokes C.M.T.

Last week we discussed the flaws and risk of a data set that has encountered a significant shift or change for Back Testing theories. Another good example of a major change of market structure that skews the data set and thereby giving false readings on Back Testing is the elimination of the “Uptick Rule.”

In 2005 after intense lobbying by special interest market participant groups, the SEC agreed to run a pilot test program on a few big blue chip stocks to see whether the Uptick Rule for selling short should be eliminated.

The Uptick Rule had been in place for decades and had been part of the reform of the stock market after the catastrophic collapse of 1929. The Uptick Rule for those of you who are new, required that the price of a stock “tick up” before any sell short order could be executed. The theory behind the Uptick Rule was that this prevented massive sell-offs that plummeted the price of a stock in seconds, as occurred in the 1929 stock market crash.

The argument from some market participant groups who actively traded short term, was that the Uptick Rule was an outdated rule that was no longer needed due to the huge volume and liquidity that the new market participant groups provided.

The test was run for 6 months and at the end of that time the SEC did eliminate the Uptick Rule for selling short. But alas, there were problems in the test study.

First of all the group of stocks chosen were big blue chip stocks, and not any small caps. Blue chip stocks are held for charter by many mutual funds and pension funds, and are held in trust by hedge funds, other funds for ETFs, and other derivatives. So the bulk of the institutional holdings for blue chip stocks are long term holds. Smaller lot investors also tend to hold these stocks for the long term. So the actual amount of short term trading, including selling short is significantly less percentage wise than a small cap stock.

The conclusion that the Uptick Rule was no longer necessary due to the high liquidity of the markets was a flawed due to the lack of inclusion of smaller cap stocks.

In addition, the market conditions at the time of the testing period were not speculative. The market was in a platform market condition with most stocks moving sideways in tighter action. This too affected the conclusions of the test.

Since the elimination of the Uptick Rule massive sell-offs have occurred. The most notable was the May Flash Crash of 2010 when a HFT algorithm went haywire. And again in 2012 with the Knight Corporation trading disaster of bad trade executions, that nearly bankrupted Knight in a few minutes.

Although curbs and other regulating computer generated monitoring are in place, the fact remains that the Uptick Rule elimination has caused the sell side of the market to experience steeper and faster price action.

This one change has had a ripple effect across the stock market. You can see it in the charts, and you may experience it in your trading.

The SEC always uses “Forward Testing” and is currently testing a new sub-penny order processing created by the NYSE for retail traders. But unless the data set is complete and relevant to current conditions, it can be a flawed test.

“Back Testing” is far more flawed in concept and scope than “Forward Testing” because it includes data that is no longer relevant due to massive changes in market structure. Be careful when you use Back Testing, to only include relevant data in your data set.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
MetaStock Partner

©2012 Decisions Unlimited, Inc.

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