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trading system optimization

There has been considerable controversy about trading system optimization. What exactly is wrong with optimizing systems? Can you go too far? Is there a happy medium?

The real issues in system optimization are complex, and they've been exacerbated by the tendency of systems developers to optimize their programs above and beyond any reasonable degree. To optimize a system is to discover the parameters that provide the best results in hypothetical back-testing. In other words, optimization is a form of discovering what would have produced the best results using numerous if-then scenarios.

Before affordable computer hardware and software were available, optimization was a long and laborious procedure. To discover the best fit, the systems developer would need to repeatedly backtrack and test several variables. If the system parameters were numerous, the process was virtually impossible. Obviously, computers have made this a quick and efficient task. Now any trader with several thousand dollars can develop optimized systems.

Such ease of testing and optimizing is both good and bad. On the one hand, it allows traders to develop, test, and refine (i.e., optimize) systems much more rapidly. On the other hand, it has opened the door to what is called curve-fitting. The simple fact is that the powerful system-testing programs now available allow traders as well as systems vendors to repeatedly test a host of timing variables, stop losses, and other risk management schemes in order to determine which combinations would have produced the best results. In effect, this procedure fits the best parameters on past history to produce the best hypothetical results. However, the conclusions reached by such methods are often specious.

The trader who tests and retests to find the best fit will eventually reach his or her goal, but the goal itself may be nothing more than a reflection of the curve-fitted results. Tests tell us what has worked in the past but may not reveal anything worthwhile about the future. Since the past is not a carbon copy of the future, it is doubtful that the optimized parameters will work in the future. The more parameters in the decision-making model, the less likely they are to work in the future.

Overly optimized results lead to false conclusions. The result will likely mean losses. For those who develop and sell futures trading systems as a business, optimization is an amazing tool that allows the creation of outstanding hypothetical performance results that, in turn, allow systems developers to make incredible claims. And claims sell systems.

Time will tell if I am wrong about overly optimized systems. Vast personal experience, however, strongly validates my conclusions. I recall recent developments regarding several popular trading systems sold by a software developer. The advertised claims were fantastic. Systems were sold for T-bond futures, S&P futures, and currency futures. The outstanding performance claims provided a strong media campaign.

Naturally, all of the proper disclaimers were made to comply with the then-current regulatory requirements. There were no disclaimers regarding optimized results, however, nor was it disclosed that not all buyers of the systems would be using the same system parameters. Because the systems were continually optimized for best results, the hypothetical track records were truly impressive. However, the results did not jibe with results experienced by those who had old versions of the software - versions that did not reflect the new optimized parameters. This is hightech deception. Recognizing that there might be legal liability, the systems developers eventually disclosed this fact in small print. Few buyers understood the meaning of the disclosure and even fewer cared, given the impressive hypothetical performance record. Naturally, buyers of the software felt that they could match the hypothetical performance.

In many cases, these traders did well initially. A customer in my brokerage firm purchased one of these programs and began trading it strictly according to the rules. The results were impressive. I began to watch intently every time a trade was made. It was uncanny how well the system entered and exited trades. It was as if the system had internalized a sixth sense about the market.

Then, after several months and excellent results, the system began to unravel. Numerous large losses occurred and performance deteriorated more rapidly than it had climbed. The dangers of an overly optimized system became apparent once again.