The Subjective Function (Part 1)

I’ve mentioned multiple times that in trading system development we’re looking for consistent profitability over time.  To do this, identification of the “subjective function” is a prerequisite. 

Much of the direction to my current work is owed to Dr. Howard Bandy.  You can read about him here:  http://www.linkedin.com/pub/howard-bandy/b/b44/270 .  In his book Quantitative Trading Systems (2007), Bandy defines the “objective function” as:

> A single-valued measurement of the fitness of a trading system. Optimization
> techniques are guided by maximizing the value of the objective function.

He also writes:

> Only you can decide which trading systems are good and which are not.
> Selection of the objective function is a management decision and must
> be made prior to extensive model development. The objective function
> itself is not a candidate for optimization.

What does this mean?

System trading is the epitome of Yin and Yang!  Beginning on 5/7/12 (http://www.optionfanatic.com/2012/05/07/strategies-vs-systems-part-i/), I wrote a number of blog posts discussing discretionary vs. systematic trading.  The upshot was that discretionary trading is subjective and systematic trading is objective.  This may be true but at the heart of a somewhat objective system development process is the very personal selection of Bandy’s objective function.   For this reason, I have chosen to call it the subjective function.

All this subjective function talk may seem highly theoretical but it really boils down to something quite simple.  On 10/4/12 (http://www.optionfanatic.com/2012/10/04/trading-system-1-spy-vix-part-4/), study the y-axis to see my subjective function:  net profit (%).  I proceeded to discuss the best combination of parameters by performance on that measure.

The only problem is that I failed to go through the process of determining my subjective function before implementing it.

Stay tuned for further discussion and a possible detour in upcoming posts.