Walking it Forward with System Validation (Part 4)
Posted by Mark on February 1, 2013 at 13:03 | Last modified: January 30, 2013 04:43In 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.
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[…] http://www.optionfanatic.com/2013/02/01/walking-it-forward-with-system-validation-part-4/, I introduced the process of Walk-Forward Analysis […]