Quality Money Management : Process Engineering and Best Practices for Systematic Trading and Investment

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STAGE 2: Overview

The spiral stage structure of K| V begs two perspectives—one, that of the loops; and two,

that of the steps. One can look at the four steps that comprise a single loop, or the three

loops that comprise each step. We will do both. This chapter will present an overview of

the three loops. The following four chapters will examine each of the four steps and each

pass over each step. The number of loops is not by any means fixed. (We decided that

three iterations were sufficient to cover the commonly encountered substeps.)

CHAPTER ◆ 13

Successful trading/investment system design necessitates research into past market

movements as a way to analyze, optimize, and validate a system—a process called back-

testing. A backtest is a simulation and statistical analysis of a trading/investment system ’ s

inputs and outputs against historical data, taking into account factors such as transaction

costs and slippage in execution. Proper optimization of the system and backtesting will

not only confirm the validity and accuracy of a system ’ s algorithms, but also its perfor-

mance and process variation. That is, backtesting will assess the trading/investment sys-

tem ’ s ability to satisfy the requirements of investors.

All trading/investment systems product performance metrics vary, and that variation

can be analyzed using statistical methods. If the trading/investment system is not in sta-

tistical control due to unknown factors, there can be no way of understanding its ability to

satisfy investor requirements with any degree of precision.^1

STEP 2:

Develop

cleaning

algorithms

STEP 3:

Perform in-sample

and out-of-sample

tests

STEP 4:

Check

performance

and shadow

trade

STEP 1:

Gather

historical

data

3

2

1 1

2

3

(^33)
2 2
11
FIGURE 13-1