Reply to thread

Hi Tech/a --

You ask about "find the optimum parameters -- optimum is always determined by the highest value of the objective function "

I think that developing trading systems must always begin with the person or organization deciding what they want the outcome to be. 

For example, organizations that have enough capital to trade many markets may be able to trade a portfolio of systems, each of which has a low percentage of winning trades but with a high win to loss ratio for those trades taken.  Individuals may be uncomfortable with that and instead prefer systems that have smooth equity curves with a high percentage of winning trades, even though the win to loss ratio is about the same.

The statistics for those two examples might be:

1:  win 30%, w/l ratio 5:1

2:  win 70%, w/l ratio 1:1

If a person is trying to trade a system that makes him or her nervous about calling in the order and sometimes overriding the signal, that person is suffering a cognitive dissonance.  In my opinion, those books that talk about the psychology of trading are often talking about ways for the trader to convince him or her self to make the trades even though that person does not believe in the system. 

I think that is all wrong.  The way to begin is to decide what kind of system you, personally -- very personally -- want.  Define the characteristics of that system.  How many trades a year (minimum or maximum), what is the minimum percentage of trades that should be winners, what is the minimum win to loss ratio, what is the maximum percentage system drawdown, and so forth.  Combine everything that is important into one objective function.  That objective function has a single value.  Every trading system over every ticker over every time period can be evaluated using this objective function with the result that every alternative has a single number associated with it -- the objective function score.

Be realistic about the objective function.  Asking for a minimum of 80% winning trades with a minimum of 5 to 1 win to loss ratio will result in system that take one trade every five years -- when the signal does come, you will not trust it.

Having chosen the objective function first, begin evaluating possible trading systems.  When choosing among alternatives, the alternative you prefer will have the highest objective function score.  If you find any case where you prefer a trading system that has a lower score to one that has a higher score, then the objective function must be modified so that the system you prefer has the higher score.  You must be willing to accept that the best, for you, system is the one at the top of the ranking.

Now begin optimizing.  After an optimization run that evaluates thousands of alternatives, the best set of values, for you, will be the set at the top of the list. 

Remember where we are headed -- automated walk-forward.  In every walk-forward step: the trading system is optimized over the in-sample data; the alternatives are ranked; the values of the optimized variable that rank highest are used to trade over the out-of-sample data; the results from all the out-of-sample periods are evaluated in one take -- trade it or discard it -- to decide whether to trade the system with real money.  The goal is to be able to click one button "Walk-forward," and see the concatenated out-of-sample equity curve appear on your screen.  If you like the looks of the equity curve, trade the system with real money.  That process only works if the objective function incorporates everything that is important to you and if alternatives with higher objective function scores are always preferred to alternatives with lower objective function scores.

Thanks for listening,

Howard

www.quantitativetradingsystems.com