Optimization simply means finding the best sets of parameters for a given market. This process can marginally improve results. However, it also carries many risks because its underlying assumption is that past performance is indicative of future price movements. Optimization can be accomplished by changing the values of the parameter you would like to optimize and then back testing these changes. Keep in mind the other parameters must remain constant for the effects of the changes to be determined. Once you find the value that
yields the highest performance in the back testing, implement it into the trading system.
Let's consider an example. Say a trader analyzed the S&P 500 and found that he or she could optimize the system by using a daily chart. This same process can also be taken to a higher degree. For example, if a simple moving average of 6 works better than 8 for an MA-crossover strategy in a given market, then 6 would be used. The problem here is not only in the assumption, but also in the fact that the system may perform worse in many other markets, thereby making it less universal.
Many system developers forgo the optimization stage for these two reasons:
• Optimization often overstates results. This is because the parameters are so specific and non-universal that any change in the market (that is, the future) can cause instability.
• In many cases, optimization will not improve performance by a meaningful degree. Slight improvements may be apparent; however, the forfeiture of universality is a high price to pay.
As a general rule, optimization should only define broad settings for parameters rather than set up specific rules - even if it was successful in backtesting and paper trading.
Troubleshooting is crucial to making your system work the way you want it to. It is important to identify any problems by observing the instances in which they occurred and then evaluating how certain conditions of several factors - such as price pattern, volume, bid/ask spread, and margin - may have caused the
Optimization can improve your results, but it is important to remember that it has
its limitations. Not only is it based on the assumption that past performance indicates the future, but it is not the stage at which the trader creates specific rules - optimization is only about defining broad settings. In the next and final installment, we will provide an overview of everything we've covered along with some advice and resources to help you gain a working knowledge of trading system design and development.
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