Bid-ask bounce is the reason tick-level signals look better than they are

[Fairman]

Bid-ask bounce is the reason tick-level signals look better than they are

When trades alternate between hitting the bid and lifting the ask, the last traded price flips back and forth even if the true value stays the same. This bounce produces a negative autocorrelation in tick returns that looks like mean reversion.

A strategy that sells after an up-tick and buys after a down-tick will appear profitable in a backtest using last prices, because it is simply capturing the bounce. In reality, to exploit it, the trader would have to cross the spread on every trade, paying exactly the amount the bounce provides.

The illusion is widespread in tick-based testing. Results look wonderful until execution costs are properly modeled, at which point the edge disappears.

To avoid the trap, test with separate bid and ask series, buying at the ask and selling at the bid. Alternatively, use the mid price for signals but charge the full spread on every fill.

Any tick-level system that does not survive that treatment was only harvesting noise.

Has a tick-level backtest ever fallen apart once bid and ask were separated?