Flushing Out the Arbitrary

In the journey to succeed with System Development or anything trading-related, critical elements in the category “what I don’t know I don’t know” must become illuminated, become analyzed, and become known.  Today I will attempt to illustrate this by describing my initial concept and the present concept System Development has become.

The reason I bought AmiBroker was to backtest systems I read about in books and on-line to verify whether the purported results were accurate.  I have talked about some initial claims (see http://www.optionfanatic.com/2012/12/05/trading-system-2-consecutive-directional-close-part-11/).  I have coded them into the software and run the backtesting to verify those claims.  I originally believed this was the entirety of due diligence required in order to obtain tradable systems.

Not even close.

Perhaps the biggest missing detail is optimization, which I also discussed in http://www.optionfanatic.com/2012/10/18/laziness-dissected.  If a trading system holds for W days (or uses X as a critical value, or Y and Z as indicator periods, etc.), how do I know whether its success was just lucky?  While the reading is inspirational and alluring (think “trader porn”), if the profits are unlikely to persist then it is simply another useless Best Seller in the minefield that is Wall Street.

Optimization forces me to flush out the arbitrary by identifying variable parameters.  The total number of potential trading systems is the product of potential values for each parameter.  I must plot the subjective function vs. values of the parameters, identify plateau vs. spike regions, and identify the viable trading system candidates.

Next up is Monte Carlo simulation to better understand potential DDs (see http://www.optionfanatic.com/2012/12/11/trading-system-3-naked-puts-part-4/ ), position sizing, and Walk-Forward Analysis.

For this trader working to learn System Development, flushing out the arbitrary has been the biggest component to date of “what I don’t know I don’t know.”  With this block now destroyed, hopefully personal and professional growth can occur at an accelerated pace.