Walking it Forward with System Validation (Part 4)

In http://www.optionfanatic.com/2013/01/31/walking-it-forward-with-system-validation-part-3/, I described validation in the third example that allowed me to test the optimized system on some new (OOS) data before risking real money.  Today I want to go one step further and introduce walk-forward analysis (WFA).

The problem with the third example is that only the last two years of data are used to validate a system optimized over the previous 13.  What would be nicer would be to generate a longer equity curve composed solely of OOS data.  This is precisely what WFA allows me to do.

Assuming that I can test and optimize the trading system on as little as two years of data, suppose for my fourth example that I begin by optimizing trading parameters over the first two years and then testing the system over the following 12 months.  The precise ratio of IS:OOS lengths is somewhat arbitrary (a point I will refocus on later) but for this example I will stick with two years:one year.  I now have one year of validation, which is less than the two years I had in Example #3.

What happens next is the key ingredient:  I slide the two-year data window forward by a year and repeat the analysis.  What results is one additional year of validation, which brings me to the end of data year #4.

In this manner, I will continue walking forward and optimizing each rolling two-year data period followed by a one-year test of efficacy.  When the data finally runs out, I will have amassed 13 years of OOS validation–potentially with different trading parameters every 12 months.  The system performance for these 13 OOS years is a much better indication of how a system will perform in real time than the performance of any single time period used for optimization.

I will continue discussion of WFA in the next post.