Way of the turtle

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Way of the Turtle

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• Optimization paradox: The act of determining the
particular parameter, such as choosing a 25-day moving
average instead of a 30-day average, reduces the predictive
value of the backtest itself.
• Overfitting or curve fitting: The system may be so
complicated that it has no predictive value. Because it is
tuned to the historical data so closely, a slight alteration in
market behavior will produce markedly poorer results.
Trader Effects
An observer effect is a concept from physics in which the act of
measuring a phenomenon sometimes affects that phenomenon;
the observer disturbs the experiment by the act of observing. A
similar thing happens in trading: The act of trading itself can
change the underlying market conditions on which the success
of a trade is predicated. I call this a trader effect. Anything that
repeats with enough consistency is likely to be noticed by several
market participants. Similarly, a strategy that has worked espe-
cially well in the recent past is likely to be noticed by many
traders. However, if too many traders start to try to take advantage
of a particular strategy, that strategy will cease working as well as
it did previously.
Let us consider the breakout strategy. If you knew that there were
going to be many large traders buying at the breakout in a relatively
thin market, what could you do to make money from them? What
strategy could you employ that would be like printing money? 
You would buy your orders ahead of those of other traders and
in so doing cause a rise in prices to the levels that triggered the
Lies, Damn Lies, and Backtests
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orders from those large traders. Then you could sell your position
back to them for a guaranteed profit; in effect you would have
moved the price to take advantage of the other buyers.
Imagine that you are a gold trader. If you knew that there would
be large buy orders from ACME, say, 1,000 contracts in August
gold at $410.50, what might you be able to do? 
If you could buy enough to reach those stops, you could make
money by selling the contracts back when the stop was hit. On the
one hand, if the price was far enough away from those stops, it
might take more money than you had to guarantee that you could
move the market to reach those buy orders. On the other hand, if
the price was close enough, say, at $408.00, a series of buy market
orders might raise the price enough to trigger those additional buy
orders from ACME.
Since you would be buying and then quickly selling right after-
ward, you might change the meaning of a breakout itself. Before
the addition of the trader effects, a breakout might have signified
that resistance had been broken, and so there was a greater likeli-
hood of favorable price movement when a breakout occurred.
However, with the addition of the new buys, which are designed
only to move the market enough to cause a breakout to occur, the
meaning of the breakout has been altered.
Let us examine this concept using a specific example. Assume
that there were no buyers willing to buy at $408.00 or higher but
there were sellers willing to sell 1,000 contracts at anything above
$409.00, and these sell orders would act as a ceiling keeping the
price from going over $409.00. Before the addition of your buy
orders, the market would not have advanced to the price of
$410.50, and so the breakout would not have happened. Therefore,