Evaluating Trading Strategies Using Economic Criteria

In the realm of trading strategy development, assessing strategy effectiveness can be approached through two distinct avenues. One approach involves evaluating the efficacy of a predictive method by employing statistical measures to gauge its accuracy and predictive power. Alternatively, effectiveness can be gauged by directly evaluating the strategy's profit and loss outcomes, providing a real-world assessment of its performance in terms of generating actual returns and managing potential losses.

In academic literature, the prevalent approach often involves the utilization of the first method, which entails assessing the predictive power of forecasting methods. Reference [1], however, examined both the aforementioned evaluation approaches. The authors pointed out,

So, what we actually state here is that for a market participant who desires to engage in trading activities using a model-based trading strategy, the choice of evaluation criteria can have a huge impact on the final outcome. Infinitesimal small differences between forecasted values of different models, that statistically may be indifferent, can actually lead to a contradicting outcome when object-based evaluation criteria are used. So, the model and the accuracy tool used must be carefully chosen, depending on what is more desireful, as they can be rather deceptive.

We agree with the authors' perspective that employing a strategy’s profit and loss for evaluation is a robust and effective approach. Nevertheless, it is important to recognize a nuanced consideration in this specific context. In cases where the forecasting of spot VIX leads to trading VIX futures, it's vital to acknowledge that VIX futures aren't equivalent to spot VIX. This distinction arises due to the need to account for the cost of carry inherent in futures trading.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Stavros Degiannakis and Eleftheria Kafousaki, Forecasting VIX: The illusion of forecast evaluation criteria, 2023, Working Papers 322, Bank of Greece.

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