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Testing - The Dangers of Curve Fitting

If you are looking to buy a ready made currency trading system from a vendor or intend building your own, you need to be aware of curve fitting. Curve fitting, is the major reason why systems that work well in back testing, fail to deliver the same results in real time trading.

What is it?

Curve fitting is simply when the trading system rules are bent to fit the data.

A trader I Know likened this to shooting at a barn door with a shotgun randomly and then drawing a chalk circle around each shot, to make it look like a perfect bulls-eye!

Traders do this very often on purpose when selling a system, while others do it without realizing the implications of what they are doing.

How to Avoid Curve Fitting

The way to avoid curve fitting is to keep your system simple and restrict it to only a few rules. A good robust forex trading system will do the following:

  1. Trade all markets with the same rules and parameters
  2. Trade all market conditions with the same rules and parameters.

All markets are the same in terms of how price is decided - don’t ever try and differentiate between trending and non trending markets. Of course this is easy when you are looking at long term price history but far more difficult, when don’t know what will happen next.

Spotting Sold Curve Fitted Systems.

If you are thinking of buying a trading system and you see a performance graph that looks great, check for the following risk disclosure statement:

"CFTC RULE 4.41 - Hypothetical or simulated performance results have certain limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not been executed, the results may have under-or-over compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profit or losses similar to those shown".

This means of course that the system has NOT been traded. The track record has simply been simulated in hindsight over past data. While not all systems that have simulated track records will fail in real time, most will. Most vendors have purposely curve fitted the track record to make the more sales.

If you see a simulation that looks realistic and this means it has normal drawdown and the upside looks realistic, simply take a look at the rules and parameters before buying and see if they make sense to you.

Never buy a black box system where the rules are not revealed. The reason for this is:

If you are following a system you have not designed yourself, you still need to have confidence in the logic to follow it with discipline. If you don’t know how and why the system works, you won’t have the confidence to follow it through periods of drawdown.

If you are building your own currency trading system then the above tips will help you avoid curve fitting and optimization of rules, if you are buying a ready made system, you can spot the ones that are more likely to be profitable and the others that you should avoid at all costs.

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