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How to See the Future
By Darren Merwitz | July 26, 2007
Live it!
Say you develop a strategy and want to check that it is not over-optimized and how it will handle itself in out-of-sample data. The best way to do that is to trade it on a demo account, going forward in real-time. Pretend it is a live strategy and that your demo dollars are real.
Walk-forward testing is, by far, one of the best tools you can possibly use in strategy development. You obviously have to use it properly and make sure that you understand what you are doing. Having a walk-forward perform well doesn’t necessarily mean it’s good. Having a walk-forward perform exactly how it is supposed to in the environment of the walk-forward is what you’re looking for.
Say I develop a ranging strategy, and my walk-forward data happens to consist of a breakout environment. If my strategy does not do well over that period, then I’m happy. Why? Because it did exactly what it was supposed to do. At that stage, I’m still not ready to run it because I’d like to see that it actually performs well when it is supposed to, but I’m not going to throw it away. If my ranging strategy performed well over the break-out walk-forward data, then I’d be a lot more worried!
There is a lot to be said about splitting your historical data in two sections. Optimizing on the first half, and treating the second half as walk-forward data. This is an amazing way to really speed up the whole walk-forward testing process. However, there is a lot to be said for subconcious bias. Because the second half of the data is not exactly 100% unknown, you may be selecting strategies that perform well in it, without actually knowing it.
The best way to guard against this is to use data that you know you have definitely never seen before and never could have predicted - i.e. future data. It is hard to slow down your excitement when you have a strategy that is almost ready and watch it trading on a demo account for 3 months while your real money is elsewhere doing other things, but the value you obtain from doing an excercise like this makes an enormous difference in your understanding and robustness of your strategy.
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