The Benefit of Hindsight in Trading System

Tuesday, January 13, 2009

Once you know something, such as the past history, pretending that you do not is very difficult. The ways a trader can delude him-/herself while back testing a trading system vary in degree of subtlety. A crude one is to develop a set of trading rules by observing the past history of the market, and apply the algorithm on paper to the same past history.

A more subtle one has to do with the choice of adjustable parameters. It is common to abstract the algorithm, and split it into the "artificial intelligence" (AI) core, capable of "learning", and adjustable parameters which may control the learning process, the application of its effects, or both. A developer would then prevent the AI from learning the future, and run a trading simulation program on historical data, having the AI algorithm fixed, for a range of parameter values and then pick the value that gives the best result. By not letting the AI learn the future, the developer reduces the level of self-delusion somewhat.

The best simulated performance would still incorporate "the benefit of hindsight" albeit in a refined way -- through the choice of the adjustable parameters. While the AI did not learn from the future directly, its way of learning would incorporate the benefit of hindsight, and the results might contain a survivorship bias of sorts. The result? In case of a poor AI, the result will be a trading strategy with a hidden "peso problem".

Below I demonstrate the quality of the Forex Automaton™ AI directly, by removing the selection step and thus the survivorship bias it brings in. I look simultaneously at the entire range of possible "ways of learning", refusing to reject those inside the range. Nor do I reject any of the possible money management styles, for the same reasons.

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