Risk Management in Trading: Techniques to Drive Profitability of Hedge Funds and Trading Desks

CHAPTER 4 Backtesting and Trade Forensics

This chapter describes how hedge funds and other disciplined traders develop trading strategies. Trading is extremely competitive and the best way to avoid losing money is to make good investments. As a result, it is common for hedge funds and other trading groups to take a systematic, disciplined approach to investing. This involves testing ideas both before and after the transaction. Before a trade is made, traders use backtesting to test strategies against historical data before they make bets with actual money. After the trade, trading forensics are used to perform a post-mortem analysis that identifies how well actual performance matched predictions that were made at time of trading.

Backtesting is a set of techniques used to analyze how trades would have performed over some historical period. This doesn’t guarantee that trades will perform the same way in the future. However, testing can give substantial insight to the potential behavior of the trade—anything that has been observed in the past has a reasonably good chance to happening again. Trading forensics re-analyzes the trade and additionally provides another layer of control for trading management to review the trading process.

For trading desks, the decision to invest money into a trading strategy is a core element of the decision to “accept risk” or to “avoid risk.” This is a strategic decision. It defines the risks that will be voluntarily taken on even if, or perhaps ...