## Slippage and Root Mean Squared Error in Model performance

REAL traders all know how important slippage is.  You wanted to buy at 20.05 but got filled at 20.07.  Then you wanted to exit at 20.55 but got filled at 20.52.  The \$0.02 on the went in and the \$0.03 on the way out is what is referred to as slippage or skid. Total slippage \$0.05

When building mix models I always incorporate slippage but where has become an increasingly important question in my work.  It’s similar to when people run a regression analysis on data that has no linear time factor built it.  You have no idea if Y preceded X or X preceded Y.  Running a linear regression doesn’t make this so.

Root Mean Squared Error or RMSE is one of many ways to compare regression models.  The formula is SQRT(mean((Observed_data- Predicted_Value)^2)).

When building models I often have a maximum profit from the trigger point (trade entry).  Back to our example. If I bought in at \$20.07 and the highest print on the chart that day was 20.77. Max Profit would be \$0.70.  My question to answer is typically what features will allow me to predict that \$0.70 with the least amount of error & risk.

SLIPPAGE MATTERS! BIG TIME! I ran a Monte Carlo. 10,000 iterations. Running the same model where slippage was not subtracted from max Profit and when it was.  These were the results.

There are MANY interpretations of this.  I’ll offer a few.

• RMSE is sensitive to large numbers creating the flaccid bi-nomial distribution in the bottom graph.  Large numbers potentially produced by small max profits and large spreads. IE CMG’s spread is about \$0.20 where could be Max Profit = 0.05.
• The top graph RMSE, max profit, is normally distributed in this model because individual stock differences for max profit are not enough to disrupt the distribution.  Which suggests that my ability to predict a stock is potentially easier.
• SPREADS MATTER! The difference between the two graphs is caused by individual stock characteristics in the spread.  Like, two people, no spreads are ever really the same.  The error for my prediction goes up as we account for individual differences.

I think this illustrates something we experience every day in life. We have general predictions about what people will do in a given context (features) but everyone often does something unique which can not be accounted for.  I believe the bottom graph illustrates this.  It also illustrates why your real life trading profits may not reflect model performance if slippage is not included.  Because what happens. When I thought I was going to make \$50.00 I only made \$35.00…. Slippage!

## The Holy Grail of Trading

Recently I started at a prop firm in NYC.  Some of the best traders in the country reside in this office and I have the privilege of hearing their insights everyday.  I’ve also been exposed to less “popular” traders but those who have turned this “casino” into a consistent cash generating business.  They have also achieved a position few have been able to actualize: the ability to withstand the test of time in the market.  However both these peoples have one similar characteristic that I feel encompasses all others.

While listening to these traders everyday, hearing their comments, their dissatisfaction and happiness when a trade nears its completion. I do not listen to their words as much as the structure to what they say.  Listening between the lines.  Their trading style is not mine nor am I them, so to imitate them would be foolish.  It would most likely lead to my own demise. There is one quality that we can learn from them that will propel us in our trading and take our lives to a higher vibration… TRUST IN YOURSELF.  It really that simple!  These top traders do not doubt their trades, they trust the moves they make, they trust their abilities to adapt their strategies to current market conditions, they trust themselves.

My experience with a friend was that he had great intuition on where the stock was likely to move next.  7/10 times he was correct, but he always scared himself out of the trade early.  Once he started to recognize and trust his intuition he began to increase his profit and in my opinion I hear him cursing a great deal less.  This quality of self should never be overlooked in trading, in whatever profession you choose, or in life.

How do you develop trust in yourself?  Start to meditate on the concept of self trust and what it means to you.  Write this down.  Next keep a detailed log of what your true self is telling you to do. Take a “snapshot” of the feeling.  If you are correct reinforce that feeling.  Most of us are programmed not to see the trust & power we hold inside.  Once you begin this practice let it flow naturally cause all the truth you need you already have.  This idea finally clicked after a good friend / guide told me flat out, “you don’t trust yourself.”  It imprinted itself on my psyche and I knew what it was these top traders possessed.  These top traders didn’t have a super mechanical trading system, they had a SUPER MENTAL SYSTEM!