Systematic Advantage #35: Makes it Easy to Stress Test Variable Settings Using Walk-Forward Optimization
Systematic trading allows for robust analysis of variable settings through a method known as Walk-Forward Optimization (WFO). This technique is an essential tool for stress-testing trading systems, as it enables traders to assess how their system would perform under different market conditions.
Walk-Forward Optimization involves optimizing a trading system on a certain historical period (the “in-sample” period), then testing its performance on the subsequent period (the “out-of-sample” period). This process is repeated multiple times, each time advancing the in-sample and out-of-sample periods, hence the term “walk-forward.”
By doing so, WFO allows traders to simulate the real-world application of their trading system, where the future (out-of-sample) performance is unknown at the time of system development (in-sample). It helps identify variable settings that not only perform well on past data but are also robust and adaptable enough to maintain profitability in the future.
Moreover, WFO facilitates the identification of over-optimized systems that perform exceptionally well on past data due to curve-fitting but fail in real-time trading. WFO contributes to more reliable and realistic backtesting results by weeding out such deceptive systems.
