The Dangers of Overfitting

4 lip 2023

Introduction
Developing effective trading strategies is a crucial aim for traders and investors in financial markets. However, it is important to be aware of the dangers of overfitting. Overfitting occurs when a trading strategy is excessively tailored to historical market data, leading to poor performance in real-time trading. This educational post explores the dangers and risks of overfitting in trading strategies and covers the importance of robustness and adaptability when developing a strategy.


What is overfitting?
It is now common place in the world of technical indicators to see videos flying around giving out "best settings" for best results or videos / guides suggesting a user changes input values to achieve a certain outcome. This can often mislead traders into chasing their tails and trying to achieve a holy grail system. This form of data analysis does have interesting perks and can help tailor an indicator to a trader however in general can lead to dangerous biases in trading.


Overfitting happens when a trading strategy performs well on historical data but fails to deliver similar results on new, unseen data. The strategy becomes too optimized for past conditions and struggles to adapt to changing market dynamics. Traders often have access to extensive historical market data and may unintentionally introduce bias by fine-tuning the strategy based on this data. This bias arises as the strategy becomes tailored to fit the specific quirks and anomalies of the past data.


Overfitting can also lead to curve fitting, where a trading strategy is precisely adjusted to match past price movements, patterns, or indicators. However, many of these patterns may be random or coincidental rather than meaningful signals. Traders risk mistaking noise for valuable information, leading to poor decision-making and losses in live trading. Just because you see good results in a backtest does not imply future results will behave in the same manor.



How do I avoid overfitting?
To avoid overfitting, traders can adopt several practices:

1. Start to use walk-forward analysis to assess a strategy's performance on different data subsets. This encourages the testing of the future results rather than forcing overfitting on the past.
   
2. Embrace simplicity: Avoid overly complex strategies, as simpler strategies with fewer parameters are often more robust and easier to interpret. It's now common place to see "oh if I take the 20ma and the RSI and the MACD and when XYZ happens it's a buy...". Avoid this behaviour.
   
3. Conduct robustness checks: Verify a strategy's performance across multiple time periods, markets, and economic conditions to ensure its adaptable.
   

https://www.tradingview.com/x/lW9z6h36/
When designing a strategy taking into account these items in the above list will help protect you against hours of backtesting complex systems. It's all very well having a strategy that backtests well however in practicality and moving forward; the strategy needs to prove itself in walk-forward analysis.

Conclusion:
Overfitting poses significant risks when developing trading strategies. By understanding these risks, traders can take proactive measures to avoid falling into the overfitting trap. Employing strong validation techniques, favoring simplicity and conducting deep robustness checks are essential for developing trading strategies that can adapt to changing market conditions and deliver consistent performance.