Are you biased?
Ok, Ok, I’m not being politically incorrect. I’m not asking about the bias we see discussed in the newspapers, on TV, or in the blogospheres. I’m talking about another kind of bias, the kind that creeps into your trading – trading biases.
The kind of bias you never know is there but yet lurks under the bed and in the closet like the green-eyed monsters used to. The kind of bias you never think about but has to be addressed by anyone who, not only develops systems but anyone who trades.
If you don’t recognize these biases, they will come out of the closet and could turn into your biggest nightmare.
When you are looking into trading with a new service, or any service, new or otherwise, you should be asking the developers about these biases. Check out if they acknowledge them and how they handle them.
Backtesting results can be distorted with Look-Ahead Bias when trading decisions are based on information that is not yet available. This generally happens because extra data is accidentally included and we simply don’t realize it. These errors are often very slight, which is why they are so easily overlooked.
They can, however, have a dramatic impact on the overall results.
Here’s an exampleOnly daily highs and lows available to you in your backtest data but you decide to build a system that bought at daily lows and sold at daily highs. Seriously, wouldn’t this be the system of all systems? It would be a machine for printing money. Problem is, in reality, you don’t know the daily high or low until the end of the day. Whereas when babacktesting you do know. Although this seems like a silly thing to do, let me assure you when you are in the midst of developing code, it is a very easy issue to overlook.
Here at QiT we have a process for developing new algorithms and one of the steps is to sniff out any kind of look-ahead biases.
Survivorship Bias addresses the concept that many data providers do not include stocks that are no longer listed. The result is that the data set you are using for backtesting will only include the stocks that have survived to this point. This makes them skewed to the positive side because they do not include stocks that have not survived. Unfortunately, in the past, your system could have signaled these stocks and there is a good probability the trade was not profitable. If the stock was not in your data base then you did not include that trade.
Here’s a scenario. You want to test how well your strategy does with the S&P 500 over the last 10 years. Would you not need a database that was able to identify which stocks were actually in the S&P 500 10 years ago? Would it be of any value if you tested only the stocks that were are in the S&P 500 today? I think not.
For more information on Survivorship Bias and why QiT is adamant about not using data with it click here.
This is a different kind of bias and has nothing to do with coding but with your own trading so I decided to plunk it in here.
Every trader thinks that they will be able to withstand more drawdown than they will actually be able to tolerate.
Tolerance Bias is a trader overestimating his ability to tolerate drawdowns. This bias is completely psychological.
Let’s take an example. You’re looking at a strategy with 20% Max drawdown. You start trading and it immediately starts into a drawdown. You go back and check the algorithms metrics and you see over the last 7 years the max duration drawdown is thirteen months. Can you stick with this system for thirteen months underwater? Probably not.
Or, once the system gets to a 15% drawdown, well within the metrics of the system, you bail. Jack D. Schwager, author of Market Wizards, says most will bail once they hit 10%. While it is easy to look at the overall return of the system and agree that it was profitable, it is naive to think that it would not be a challenge to stick to the system at its low point.
You need to take these numbers into account when deciding on a mechanical system. Well, actually you need to take these numbers into account when trading any system.
Know the Metrics that are Important
If you find a trading system that is profitable, you need to trade it long term, or at least as long as its longer drawdown. I have not found a service anywhere that will give you the Max Drawdown duration, except QiT, of course, but it is a very important number to know.
While this can be challenging, you must find a way to stick to the plan, even if it seems boring or not worth your time in the beginning. In my opinion, trading should be boring if you are going to succeed.
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
Take our 30-day free trial and see why we can say, “If awesome were inches, we’d be the Effiel Tower.”