Determining Optimal Trading Rules Without Backtesting

Abstract

Calibrating a trading rule using a historical simulation (also called backtest) contributes to backtest overfitting, which in turn leads to underperformance. In this paper we propose a procedure for determining the optimal trading rule (OTR) without running alternative model configurations through a backtest engine. We present empirical evidence of the existence of such optimal solutions for the case of prices following a discrete Ornstein-Uhlenbeck process, and show how they can be computed numerically. Although we do not derive a closed-form solution for the calculation of OTRs, we conjecture its existence on the basis of the empirical evidence presented.

Keywords: Trading, optimization, backtesting, overfitting, simulation

JEL Classification: G0, G1, G2, G15, G24, E44