Optimisation of Trading Strategies using

Parameterised Decision Rules

N. Towers and A. N. Burgess
Department of Decision Sciences
London Business School
Sussex Place, Regents Park,
London, NW1 4SA, UK.
E-mail: {ntowers, nburgess}@lbs.ac.uk

Abstract. In the context of a dynamic trading strategy, the ultimate purpose of

any forecasting model is to choose actions which result in the optimisation of
the trading objective. In this paper we develop a methodology for optimising an
objective function, using a parameterised decision rule, for a given forecasting
model. We simulate the expected trading performance for different decision
parameters and levels of prediction accuracy. We then apply the technique to a
forecasting model of mispricing within a group of equity indices. We show that
optimisation of the proposed decision rule can increase the annualised Sharpe
Ratio by a factor of 1.7 over a naive decision rule.

Introduction

In recent years considerable research effort has been devoted to the development of
financial forecasting models which attempt to exploit the dynamics of financial
markets. Research in financial forecasting has applied and often extended techniques
developed in the fields of machine learning, non-parametric statistics and time series
modelling.
In the context of a dynamic trading strategy the ultimate purpose of any financial
forecasting model is to choose actions (i.e. trading positions) which result in
optimisation of a specific trading objective. A standard approach to decision making
under uncertainty is to decompose the process into two independent steps: first the
building of a predictive model and then secondly, the selection of an optimal decision
rule which converts the prediction into an action.
The financial forecasting community has mostly neglected optimisation of this
second step with trading performance measured using an arbitrary decision rule.
Research that does optimise trading systems use methodologies that maximise the
trading objective by building models that combine the forecasting and decision
making steps. Examples of these include using reinforcement learning by Moody in
Perspectives on Financial Engineering and Data Mining, Proc. IDEAL 98. Edited
by L. Xu et al, Springer-Verlag

[1] and neural networks by Choey & Weigend in [2]. In this paper we consider the
forecasting and decision modules as independent tasks and explore issues involved in
the selection and optimisation of trading rules for the decision making step. We show
how this choice affects the performance of the whole decision making process.
In section 2 we present an example which motivates the importance of the choice of
decision rule by showing that the same forecasting model can significantly outperform
or even underperform depending on the decision rule. We construct a forecasting
model based upon relative value between the UK and Swiss equity indices and show
that the mispricing exhibits predictability. We then apply three trading rules that
convert the relative value signal into a trading position. We show how the different
trading rules significantly effect the investment performance.
In section 3 we investigate the optimisation and selection of trading rules for
predictive models. We devise a simplified framework (i.e. no transaction costs,
borrowing costs, etc) and use it to optimise a parameterised decision rule given a
forecasting model. To build the simplified framework a methodology is developed for
generating synthetic forecasts from a predictive model with variable but known
prediction accuracy. A parameterised set of trading rules are devised which represents
the trading position of a single risky asset given the predicted percentage return of the
asset. In section 4 we present simulation results for selected values of the trading rule
parameters and levels of prediction accuracy. A typical trading objective (annualised
Sharpe Ratio) is maximised by optimising the trading rule parameter given the
prediction accuracy of the model.
In section 5 we apply the technique to a real world forecasting model that estimates
the relative mispricing between a group of equity indices. We show that optimising the
decision step using a parameterised trading rule increases the annualised Sharpe Ratio
by a factor of 1.7 over a naive decision rule.

Example

To motivate the importance of the choice of decision rule for a relative value price
series was generated between the Swiss and UK equity indices. Data was collected at
10-minute intervals over a 20-day period and the percentage relative price estimated as
shown in figure 1.
Relative Price: FTSE v SSMI

1.8

6.00%

1.6

5.00%

1.4

4.00%

1.2

3.00%

1
2.00%

0.8

VR1

0.6

VR2

1.00%
0.00%
-1.00%

0.4

-2.00%

0.2

-3.00%

-4.00%

VR5
VR10
1

11

16

21

26

31

36

41

46

Fig. 1. The left hand graph shows the relative price series between FTSE and SSMI indices.
The right hand graph shows the variance ratio profile for the series.

The variance ratio profile in figure 1 shows the values of the variance ratio up to 50
time periods. For a random walk process we expect the variance of the period
increments to approximately equal times the variance of the single period increments
so the variance ratio will be close to one. In figure 1 the variance ratio function is
significantly below one which indicates negative autocorrelation and so meanreverting or cyclical behaviour.
Three simple but plausible trading rules where devised which converts the
mispricing into a trading position as follows:
D m - m
t

t-

(1)

where D is the trading position and m the mispricing at time t. For trading rule 1,
and are zero. For rules 2 and 3, and are 1 and 100, and 1 and 10 respectively.
Figure 2 shows the equity curves, annualised Sharpe Ratio and profit (ignoring
transaction costs) for the 3 different trading rules. Comparison of the three rules shows
that they generate significantly different equity curves with the cumulative profit
varying from -4.63% to 10.21%. Note that, rule 1 is the most profitable, rule 3 most
consistent in terms of Sharpe ratio, and rule 2 illustrates that negative returns can be
achieved for forecasting models with positive prediction accuracy. Overall this
example shows that the choice of decision rule can dramatically effect the
performance of a trading strategy.
Equity Curves
15%

Annualised Sharpe Ratio

10%

(1)

(2)

(3)

3.6

-2.2

3.8

5%
PL(Stat)
PL(Cyc100)
PL(Cyc10)

0%

-5%

Profit
(1)

-10%

(2)

10.54% -4.63%

-15%

(3)
3.16%

Fig. 2. shows the equity curves, Sharpe ratio and profit of 3 different trading rules (ignoring
transaction costs).

Decision Framework

In this section we design a dynamic decision framework to represent a synthetic

trading system for one risky asset. We show how to generate predictions of the risky
asset, which simulate the output from a well-specified forecasting model of known
prediction accuracy. A parameterised set of decision rules are proposed and their
consequences are given in terms of expected return. The method assumes the

generated predictions have a level of prediction accuracy, measured in terms of the

correlation coefficient between predicted and actual asset returns.
Let an asset price series, y, an explanatory variable, x, and a noise variable, , be
defined by
y = x + t where xt ~ NID(0,x2)
(2)
t

and t ~ NID(0, )
2

where represents a constant information coefficient between the explanatory

variable and the asset price. The explanatory variable reflects the deterministic part of
the price signal and the noise term refers to the stochastic part.
Suppose the variance between the explanatory variable is equal to the variance of
the actual returns. Standardising the normal distributions for the explanatory variable
and the asset return allows the variance of the noise term to be defined as

2 =1 - 2

(3)

Dt = m |ut | sign(ut )

(4)

We define the forecasting model as ut= xt where for a well specified predictor =||.
The absolute value is used so that the information content of the predictive model can
be negative. If | ||| then the predictor is biased.
We have now defined a data generating process for well-specified forecasting
models with a variable degree of predictability.
2
The variance of the predictions is y= and the covariance between predicted and
asset price returns is yu = . The correlation coefficient is given by y= and is
considered to be the measure of the prediction accuracy of the forecasting model. The
2
R of the model is then equal to the variance of the predictions as expected for a wellspecified model.
Next we devise a parameterised decision rule that converts a predicted return into a
trading position. The difference between the new and previous trading position defines
the amount of the asset that must be either bought or sold. A set of decision rules D,
can be investigated by defining two parameters k and m as follows:
k

where ut is the forecast return and Dt the trading position at time t.

When k=1 the decision rule is a linear function with slope m; when k=0 the rule is
a step function between two states +m and -m1. Other positive values of k and m give
additional non-linear decision functions. Figure 3 shows the parameterised decision
rule for 4 values of k. The parameter m is equivalent to a leverage factor with no upper
limit. This parameterised decision rule is a generalisation of the optimal solution of the
2
risk averse investor with no leverage constraint. In this case k=1 and m= / ,
where is the risk aversion parameter for the utility function, is the expected return
and the expected standard deviation of returns.

For ut and k=0, D assumes 0 =0 using Lopitals theorem.

0

Parameterised Decision Rule

1.5

position

1
k=0 m=1

0.5

k=0.5 m=1

0
-1.5

-1

-0.5 -0.5 0

0.5

k=1 m=1

1.5

k=2 m=1

-1
-1.5
forecast

Fig. 3. shows the decision rule for 4 values of parameters k and m.

The expected investment return for a decision epoch is defined to be the average of
the trading position multiplied by the asset price return over n time periods. The
expected mean and variance of the investment returns can then be used to form a risk
adjusted performance measure for the trading objective. In this paper we consider the
ratio of average return divided by standard deviation of return, defined by Sharpe in
[4]. The trading performance will be some function of both prediction accuracy, and
the decision rule parameter k. In the next section we investigate this relationship by
varying these parameters.

Simulation Results

The investment returns were simulated for different values of the decision rule
parameters and levels of prediction accuracy. The mean and variance of investment
returns are shown for three values of k in figure 4. From these results it is clear that
the mean and variance are sensitive to both prediction accuracy and the decision rule
parameter k.
Expected Variance

Expected return
1.2
1
k=1

variance

return

0.8

k=0

0.6

k=0.5
0.4
0.2
0
0.05

0.2

0.35

0.5

0.65

0.8

1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
0.05

k=1
k=0
k=0.5

0.2

0.35

0.5

0.65

0.8

0.95

prediction accuracy

0.95

prediction accuracy

Fig. 4. shows mean and variance of expected investment returns per decision epoch for three
values of the decision parameter, k, and varying prediction accuracy.

The Sharpe ratio is now calculated for varying levels of prediction accuracy and
values of decision parameter, k. Note that the trading rule parameter, m, is a common
multiplying factor of both return and variance and so does not effect the value of the
Sharpe Ratio. It is therefore ignored for this performance metric.
The left hand graph in Figure 5 shows how the optimal trading rule parameter, k,
varies with the prediction accuracy of the model. The graph shows that the optimal
value of k decays exponentially as the prediction accuracy of the model increases. The
right hand graph in figure 5 shows trajectories of expected position in return-risk space
for three different values of trading rule parameter for increasing prediction accuracy.
This graph shows how the significance of the choice of trading rule parameter, k,
effects the mean and variance of returns.
Return/Risk Plot for varying prediction accuracy
1.2

4
3.5
3
2.5
2
1.5
1
0.5
0

1
0.8
mean

optimal k

Optimal value of Trading parameter, k

k=1

0.6

k=0
k=0.5

0.4
0.2
0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

prediction accuracy

0.5

1.5

variance

Fig. 5. The graph on the left shows the estimated optimal value of the trading rule parameter, k,
for different levels of prediction accuracy. The graph on the right shows the trajectories of
expected position in return-risk space for different values of trading rule parameter, k, by
increasing the prediction accuracy.

The key finding of these results is that the Sharpe Ratio, for a given level of
predictability, varies significantly as a function of the trading parameter, k. Therefore
maximisation of this parameter can significantly improve the performance of a trading
strategy. In the next section we apply the decision making methodology to a real
application within statistical arbitrage.

Application within Statistical Arbitrage

We use the term statistical arbitrage as a generalisation of traditional zero risk

arbitrage where the price dynamics of a related group of assets are known and
exploited in order to achieve a profit. In this wider sense the relationships are
statistical rather than known and so statistical arbitrage trading is no longer risk
free and so risk should be controlled in the trading strategy.
Hourly price data was collected from 15 May 1998 to 7 July 1998 for a group of
equity index futures (FTSE, S&P, DAX, CAC, FIB and SSMI). A methodology using
principal component analysis developed in [5] was applied to the data to estimate
relative weightings of the Equity indices and so generate a relative mispricing, p as
follows:

p = 0.58 FTSE + 0.17 S&P 0.15 DAX 0.76 FIB + 0.19 SSMI

(5)

The left hand graph of figure 6 shows the value of the mispricing through time and the
right hand graph is the variance ratio profile for the mispricing. It shows that the
variance ratio of the mispricing is below one and so has significant cyclical or mean
reverting behaviour.
3

Relative mispricing of Equity Indices

2.5

0.015
0.01

VR1
VR2

value

0.005

VR5
1.5

0
-0.005 0

100

200

VR10

300
1

-0.01
-0.015

0.5

-0.02
0

time

11

16

21

26

31

36

41

46

Fig. 6. The left hand graph shows the estimated mispricing, p between the prices of FTSE,
S&P, DAX, FIB and SSMI futures indices. The right hand graph shows the Variance Ratio plot
for the mispricing.

The mean reversion in the mispricing allows us to define a predictive model as the
negative of the relative mispricing. For this forecasting model the prediction accuracy
(i.e. the correlation between the forecasts and the change in the mispricing) was
measured to be 0.12.
The trading objective was specified as maximising Sharpe Ratio and so for this
level of prediction accuracy we expect, from the simulation results in section 4, that
the optimal value of k will be 1.2. Using the sample data to optimise k results in a
value of 1.8 as shown in the left hand graph in figure 7.
Equity Curve

0.14

0.12

0.2
0.15

0.1

0.04

256
271

241

211
226

0
181
196

151
166

0.02

k=1.8

121
136

k=1.2

0.05

76
91

synthetic

106

0.1

sample

46
61

0.06

16
31

0.08
3

profit

sharpe ratio

Anualised Sharpe Ratio

-0.05

-0.1

parameter, k

time

Fig. 7. The graph on the left shows the Sharpe Ratio for different values of parameter k for the
synthetic and sample data. The graph on the right shows the equity curves for the two optimal k
values.

It is proposed that the difference between the two optimal k values is due to
assumptions of normality and an unbiased forecasting model in the synthetic data
generating process which is violated in the statistical arbitrage forecasting model.

The right hand graph in figure 7 shows the equity curves for the two optimal k values
assuming no transaction costs.

Conclusions

We have described a methodology which is intended to optimise the objective of

the trading strategy using a parameterise decision rule. We apply this methodology to
a forecasting model, based upon principal component analysis, of relative mispricing
between Equity indices. The prediction accuracy of the forecasting model is measured
and the parameterised decision rule is optimised for the synthetic data and the sample
data. The methodology improves the trading performance from an annualised Sharpe
ratio of 3.14, for the naive decision rule (k=0), to 5.31 for the optimal decision rule, a
factor of 1.7. To gain this level of trading performance would approximately equate to
improving the prediction accuracy of the forecasting model from 0.12 to 0.165, a
factor of over 35%.

References

1. J. Moody, Optimisation of Trading Systems and Portfolios, Proceedings from

Fourth International Conference on Neural Networks in the Capital Markets, 1996.
2. M. Choey, A. S. Weigend, Nonlinear Trading Models through Sharpe Ratio
Maximization, Proceedings from Fourth International Conference on Neural
Networks in the Capital Markets, 1996.
3. A. N. Burgess, Controlling nonstationary in statistical arbitrage using a portfolio
of cointegration models, Proceeding from Fifth International Conference on
Computational Finance, 1997.
4. W. F. Sharpe, Mutual fund performance, Journal of Business pp. 119-138, 1966.
5. A. N. Burgess, N. Towers, Statistical arbitrage models in Equity and Fixed
Income markets, Technical Report, London Business School, 1998.