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## A Statistically Significant Edge

Last week we discussed that just because a trading system is making money doesn't prove it has an edge. It means you have both the chance that the system has an edge - and also that it may just be lucky.

One of our advisors wrote back to see if they understood that approach.

Well, that is correct. In fact, if we were developing coin-flipping agents that would be as far as we would be able to go. However, we are in luck because our problem has an extra dimension, which makes it possible to filter-out some of the "lucky" Bots from our trading systems.

Determining Which are the Best Systems.There are several ways to determine whether a trading system has a persistent edge. For example, we can look at the market returns during the trading period and compare and contrast that with our trading results.

This is significant because many systems have either a long or short bias. That means even if a system does not have an edge, it would be more likely to turn a profit when its bias is in alignment with the market.

We try to correct that bias using some math and statistical magic, in order to determine whether the system has a predictive edge.

It Is a Lot Simpler Than It Sounds.Imagine a system that picks trades based on a roulette spin. Instead of numbers or colors, the wheel is filled with "Go Long" and "Go Short" selections. As long as the choices are balanced, the system is random. But what if the roulette wheel had more opportunities for "long" selections than "short" selections?

This random system would appear to be "in-phase" whenever the market is in an uptrend. But does it have an edge?

One Way To Calculate Whether You Have An Edge.Let's say that you test a particular trading system on hourly bars of the S&P 500 Index from January 2000 until today.

According to the law of large numbers, in the case of the "roulette" system illustrated above, correcting for bias this way, the P&L of random systems would end up close to zero … while systems with real predictive power would be left with significant residual profits after the bias correction.

While, the math isn't difficult … the process is still challenging because it takes significant resources to crunch that many numbers for hundreds of thousands of Bots.

The good thing about RAM, CPU cycles and disk space is that they keep getting cheaper and more powerful.

Posted at 01:38 AM in Business, Ideas, Market Commentary, Science, Trading, Trading Tools | Permalink

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