I am backtesting an equity trading strategy which trades only once per day. Is there a general rule of thumb for the reasonable upper bound on the rate of return of such a strategy? For example, a 2000% return over a week might be unrealistic, but a 20% return is possible. Identifying a reasonable limit may help me identify faulty strategies.
Answer
I believe the concept you are looking for without really knowing it is the information coefficient (IC). IC is the correlation between your forecast and actual subsequent returns. If your IC is 1 (perfect correlation, also known in this context as perfect foresight), then your maximum return is the compounded sum of the greatest daily return of any stock in your universe (or of the difference between the greatest and lowest return, in case of a long-short strategy). For a lower IC, you can simulate what returns are realistic by artificially constructing a signal starting with realized returns and adding noise to get the desired IC.
A separate question is what is a realistic IC. I'm not sure, but I doubt any strategies can achieve higher than 0.1.
For more details, see Active Portfolio Management by Grinold and Kahn.
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