Evaluation and Optimization of Trading Strategies

Robert Pardo is a recognized expert in the design and testing of trading strategies and computerized trading applications, and a long-standing professional money manager. He is founder and President of Pardo Capital Limited, a professional money management firm; Pardo Group Limited, a consulting firm; and Pardo Analytics Limited, a proprietary market analysis services firm. Since 1983, Pardo has continuously updated his software as well as designed, programmed, and documented versions of various commercial trading applications. He has worked as a consultant with world-class trading firms such as Goldman Sachs, Transworld Oil, and Daiwa Securities, and created the XT99 trading platform as a joint venture and ongoing strategic alliance between Pardo Capital Limited and Dunn Capital Management. Contact Robert at rep@pardocapital.com, or go to his Web site at http//www.pardocapital.com.

• Foreword xvPreface xviiAcknowledgments xxixIntroduction 1Chapter 1 On Trading Strategies 5Why This Book Was Written 7Who Will Benefit from This Book? 8The Goals of This Book 10The Lay of the Land 10Chapter 2 The Systematic Trading Edge 17Discretionary Trading 18Raising the Bar 19Verification 22Quantification 24Risk and Reward 24The Performance Profile 26Objectivity 27Consistency 29Extensibility 32The Benefits of the Historical Simulation 33Positive Expectancy 34The Likelihood of Future Profit 34The Performance Profile 35Proper Capitalization 35A Measure of Real-Time Trading Performance 36The Benefits of Optimization 37The Benefits of the Walk-Forward Analysis 38The Advantages of a Thorough Understanding 39Confidence 40Strategy Refinement 41Chapter 3 The Trading Strategy Development Process 43Two Philosophical Approaches to Strategy Development 44The Scientific Approach 44The Path of Empirical Development 45An Overview of the Trading Strategy Design Process 47Step 1: Formulate the Trading Strategy 49Step 2: Translate the Rules into a Definitive Form 49Step 3: Preliminary Testing 50Step 4: Optimize the Trading Strategy 51Step 5: The Walk-Forward Analysis 52Step 6: Trade the System 53Step 7: Evaluate Real-Time Performance 54Step 8: Improving the System 55Chapter 4 The Strategy Development Platform 57The Scripting Language 58Diagnostics 59Reporting 62Optimization 68The Objective Function 68Speed 68Automation 69Walk-Forward Analysis 69Portfolio Analysis 70In Conclusion 71Chapter 5 The Elements of Strategy Design 73The Three Principal Components of a Strategy 74Entry and Exit 74Risk Management 74Position Sizing 75An Overview of a Typical Trading Strategy 75A Trade Equals an Entry and an Exit 76Entry Filters 78The Management of Risk 79Trade Risk 80Strategy Risk 82Portfolio Risk 84The Management of Profit 85The Trailing Stop 85The Impact of Overnight Change on the Trailing Stop 87Profit Targets 87The Impact of Overnight Change on Target Orders 88Position Sizing 89Advanced Strategies 91Summary 92Chapter 6 The Historical Simulation 93The Essential Reports 94The Performance Summary 94The Trade List 94The Equity Curve 107Performance by Period 108The Importance of Accuracy 109Software Limitations 109Rounding Issues 109Phantom Trades 111Price Orders 112Realistic Assumptions 113Price and Trade Slippage 113Opening Gap Slippage 115Opening and Closing Range Slippage 116Slippage Due to Size 117The Significance of Slippage 117Limit Moves 118Major Events and Dates 118Historical Data 120Stock Prices 120Cash Markets 120Futures Markets 121The Continuous Contract 124The Perpetual Contract 124Adjusted Continuous Contracts 125The Size of the Test Window 126Statistical Requirements 127Sample Size and Statistical Error 127How Many Trades? 129Stability 129Degrees of Freedom 130Frequency of Trading 131Types of Markets 132The Bull Market 132The Bear Market 134The Cyclic Market 135The Congested Market 137Efficient Markets 137The Life Cycle of a Trading Strategy 140Window Size and Model Life 141Chapter 7 Formulation and Specification 145Formulate the Trading Strategy 145Specification—Translate the Idea into a Testable Strategy 147Make a Vague Idea Precise 150Chapter 8 Preliminary Testing 157Verification of Calculations and Trades 158Calculations 159Trading Rules 159In Summary 164Theoretical Expectations 164Preliminary Profitability 166The Multimarket and Multiperiod Test 169Selecting the Basket 169Determining the Length of the Test Period 171Segmenting the Data 171The Test 172The Results of the Test 177Chapter 9 Search and Judgment 179Search Methods 180The Grid Search 181The Prioritized Step Search 185Hill Climbing Search Algorithms 188Multipoint Hill Climbing Search 189Advanced Search Methods 191Simulated Annealing 193Genetic Algorithms 195Particle Swarm Optimization 197General Problems with Search Methods 198The Objective Function 201A Review of a Variety of Evaluation Methods 203Multiple Evaluation Types 208Chapter 10 Optimization 211Optimization Contra Overfitting 213A Simple Optimization 214The Optimization Framework 216The Parameters 216The Scan Range 218The Historical Sample 220The Objective Function 222The Optimization Evaluation 222A Multimarket and Multiperiod Optimization 223The Evaluation of the Optimization 225The Robust Trading Strategy 225The Robust Optimization 227The Statistically Significant Optimization Profile 227The Distribution of the Optimization Profile 229The Shape of the Optimization Profile 231How Does the Strategy Respond to Optimization? 235Does the Strategy Deserve Further Development? 236Chapter 11 Walk-Forward Analysis 237Is the Trading Strategy Robust? 238Robustness and Walk-Forward Efficiency 238The Cure for Overfitting 239A More Reliable Measure of Risk and Return 241Assessing the Impact of Market Changes 241The Best Parameter Set for Trading 242The Theory of Relevant Data 243Peak Performance 243Statistical Rigor 244Shifting Markets 245The Varieties of Market Conditions 245The Walk-Forward 247The Role of the Walk-Forward 247Setting up a Walk-Forward 248An Example of a Walk-Forward Test 250The Walk-Forward Analysis 251The Purpose of the Walk-Forward Analysis 252An Example of a Walk-Forward Analysis 255Is the Strategy Robust? 256What Rate of Profit Should We Expect? 260What Is the Risk? 261Walk-Forward Analysis and the Portfolio 261Chapter 12 The Evaluation of Performance 263The Trading Strategy as an Investment 263The Dimension of Risk 264Compare the Strategy to the Alternatives 264Maximum Drawdown and Trading Risk 265Maximum Drawdown in Context 267Maximum Drawdown and the Trader 268Maximum Run-up and the Trader 269Trading Capital and Risk 270Risk Adjusted Return 272Reward to Risk Ratio 273Model Efficiency 273Consistency 276Patterns of Profit and Loss 277Chapter 13 The Many Faces of Overfitting 281What Is Overfitting? 282The Abuse of Hindsight 284The Case of the Overfit Forecasting Model 286The Case of the Overfit Trading Model 289The Symptoms of an Overfit Trading Model 290The Causes of Overfitting 291Degrees of Freedom 292Measuring Degrees of Freedom 292Degrees of Freedom, Sample Size and Startup Overhead 293Trade Sample Size 295Optimization Error 1—Overparameterization 296Optimization Error 2—Overscanning 297The Big Fish in a Small Pond Syndrome 298The Walk-Forward Test 298Chapter 14 Trading the Strategy 301The Mental Aspects of Trading 302Return on Investment 303Poor Strategy 303Market Contraction 303Unseen Market Conditions 304Superior Alternatives 305Maximum Risk 305Real-time and Evaluation Performance 308Comparing the Evaluation and Trade Profile 310Understanding the Test Profile 311Performance Quirks 313The Windfall Profit 315The Losing Run 316Flat Production 316In Conclusion 317Notes 319Index 323

"... an essential read." (The Technical Analyst, August 2008)