New Techniques  |  MAY 1999

Using A Constant Investment Size For Stock Trading Systems by Jack Schwager

Using A Constant Investment Size For Stock Trading Systems by Jack Schwager The highest high to the lowest low in the price history of an individual stock can vary tremendously, especially when stock splits occur. This large range of price history can distort the returns of a trading system. This noted analyst explains the steps to adjusting stock data to avoid these distortions. At first glance, the issue of price data appears to be far more straightforward for stocks than it is for futures. The system developer in futures is faced with the significant problem that the life span of individual futures contracts is limited. This requires linking different futures contracts into a single series. (Readers interested in an evaluation of different approaches in linking futures contracts should refer to my article in the October 1992 STOCKS & COMMODITIES.) Stock traders would appear to be spared any price data–related complications insofar as each stock is a single price series. Not so fast! Although stock price data can be used without modification, doing so without an additional adjustment can lead to enormous distortions. Most of those testing trading systems on stock data commit a major error. The crux of the problem? When a system is tested, the implicit assumption is that each trade is for the same share size. Imagine testing a system on a portfolio of stocks ranging in price from $2 to $100. Would it be reasonable to test the system using an assumption of equal share size in all markets? Figure 1 illustrates the consequences of trading two disparately priced stocks ($2 and $100) in the same position size. As can be seen in the top table, an equal dollar-price change in each stock would have an equal impact on profit/loss but represent a 50% change in the low-priced stock and only a 1% price change in the high-priced stock. The lower table shows that an equal percent-price change in each stock would have 50 times the dollar impact in the high-priced stock as in the low-priced stock. It makes no sense to trade stocks priced at widely disparate levels in the same position size.

by Jack Schwager