Lingering Quandaries about System Development (Part 1)

While this series is strictly personal, I do believe that anyone seeking to master System Development will need to arrive at their own resolutions to these issues.  On my journey, I remain “in consolidation” due to conflicting subdivisions of System Development.  More than anything else, this series will help me keep track of where I’ve been and where I am so that I can better understand where I still have to go.

My first unresolved issue is identification of an acceptable subjective function.  I addressed this in a six-part series beginning with http://www.optionfanatic.com/2012/10/04/the-subjective-function-part-1.  In the end, I settled on Risk Adjusted Return / Maximum Drawdown (RAR/MDD).  I like systems that are surgical in their efficiency–systems that trade infrequently but generate large profits when triggered.  RAR rewards systems for decreased exposure.  I also think MDD should be factored into system evaluation.  Drawdown (DD) becoming too large to bear threatens to stop me from trading a system.  DD will keep me awake at night because DD gets me thinking about Ruin.

My initial foray into System Development involved backtesting one ticker.  Through that exercise, I began to develop a sense for how RAR/MDD varies.  The problem arose when I expanded the backtest to include other tickers and encountered a drastic reduction in RAR/MDD.  In retrospect, this makes sense because trading multiple tickers increases exposure proportionally.  RAR is therefore decreased along with the subjective function.  Comparing this to values seen previously was like comparing apples to oranges and I could not relate.

One alternative to circumvent this problem is to backtest one ticker at a time.  I would then see RAR/MDD in an apples-to-apples fashion across tickers.  Another alternative is to choose a different subjective function altogether.

I will explore these possibilities in my next post.