Why High Frequency Trading cannot be backtested

The reason is simple: as far as HFT impacts on the first price (the highest one for selling operations, the lowest for buying), in a real environment HFT changes the market.

The impact could be minimal for FX markets, where high volumes of transactions are placed, but exists and has effects. Or the impact could be enormous in local stock markets, for instance, where a "touch" to bid/offer prices changes them, modifying market prices and behavior of other actors.

Market impact could be simulated, but, in this case, we have to backtest the simulation.... an impossible fact by definition.

What is Algorithmic Trading

My previous post, trying to define Systematic Trading, mentions Algorithmic Trading.

As it's described in wikipedia, use of computer programs to materialize trading orders using an algorithm which decides when and how should be traded.

For instance, an algorithmic trading algorithm may be "try to follow VWAP". Traders may use this algorithm to buy (or sell) 1Mill euro of TEF.MC, fixing a level of aggressive, maximum and minimum prices and time to place all stock orders.

Algorithms used in algorithmic trading are well-known. In a future post I will enumerate some of them.

As examples of Algorithmic Trading Systems are (both two commercial) Sungard GLStream, Progress and (opensource -under development-) AlgoTrading.

Algorithmic Trad. is, in fact, a particular case of Systematic Trad. necessary when not enough liquidity and/or high market impacts are expected when trading.

What is Systematic Trading

Systematic trading is a way of defining trade goals, risk controls and rules that can execute trade orders in a methodically way.

Thanks to the methodically approach, rules can be tested using past data.

It does not need to include the use of computers, but is almost impossible to achieve trading goals without using a computer and a systematic trading system in which rules are programmed. Systematic traders employ technology to capture profit opportunities.

The opposite is discretionary trading. Compared to systematic trading, discretionary trading has more influence from emotions, no easy possibilities of backtesting and a limited risk control

Similar ideas are algorithmic trading and quantitative trading. But algorithmic trading is more related to how to trade an order or a set of orders, using a set of well-known algorithms. Quantitative trading includes all those kind of trading (systematic, discretionary, algorithmic, HFT...) which uses too quantitative techniques to decide trading options and executions.