Curve Fitting Trading Strategies – (Examples and Backtest)

Curve fitting is when a strategy or edge is not fit to market behavior, but market noise, leading to failure in live trading. Curve fitting is overoptimization that is unlikely to fit into future unknown data.

You have probably read about curve fitting in trading books, trading magazines, and social media. The danger of Curve fitting is ubiquitous when designing trading strategies. It has the potential to ruin your trading career if not dealt with correctly and can be hard to notice, even for traders with decades of experience. In this article, we will learn what curve fitting is, and why you should try to avoid it.

(Before we go on we’d like to mention that we have a backtesting course that covers all aspects of how to backtest.)

Part I: What is curve fitting?

Backtesting in search of edges

When we perform backtests, we analyze data in search of recurrent patterns that have predictive potential. In other words, we want to know if the tested pattern can tell us when the market is prone to going up or down so that we can be in the market only when it is favorable to us. If we succeed to find patterns that we think mirror market behavior, we have a trading edge.

Since our trading business is, or at least should be entirely reliant on edges, their quality and robustness dictate how well we cope with carving out profits in the market. Therefore, it is critical that our edges continue to work well also into the future if we want to make any money.

A thought experiment

Insinuate that your observation of what you presume is an edge, is flawed and holds no merit. Insinuate that you cannot know if your edge will continue to deliver going forward and that an overwhelming majority of patterns you call edges, will not work at all.

Quite scary, isn’t it, when you are about to risk your own money on those very edges?

Well, this is not a thought experiment. It is reality.

The harsh truth about observations of market behavior

When we search for edges in the markets, most of what we assume is an edge, will be outright garbage! True edges are hard to find, and in your search, you will sometimes be completely certain that you have an edge ready to trade, only to see it fall apart completely once exposed to new market data. This is one of the a