How To Avoid Curve Fitting During Back Testing

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Computerized back testing has been a boon for us traders. At the click of a few buttons we can evaluate new trading strategies and ideas across different instruments and time frames and through optimization determine the strategy parameters that yield the best results.

For those new to trading, the meaning of back testing is:

Backtesting is the process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital. A trader can simulate the trading of a strategy over an appropriate period of time and analyze the results for the levels of profitability and risk. – Investopedia

Unfortunately with computerized back testing we also need to deal with the curse of curve fitting. Curve fitting occurs when the strategy parameters are tuned so that they produce optimized results for the specific set of historical data that was tested.

With any other set of testing data the results might be radically different. For example we might run a test over a period that saw a huge price swing due to a major news event.

A curve fitted strategy may be tuned to capture the maximum profit from those swings thus inflating its overall results. Take away that swing and the same parameters would yield drastically reduced or even negative results.


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