Ok, yes, I understand that many of you experienced traders feel that curve fitting (aka overfitting aka data fitting) is such a rudimentary (and over-blogged) topic. However, understanding this concept is extremely important for designing and testing effective trading strategies. Thus, for those of you who are new to trading; make sure you thoroughly understand this foundational theory!
Understanding Curve Fitting
Definition (from Wiki)
In statistics and machine learning, overfitting (curve fitting) occurs when a statistical model describes random error or noise instead of the underlying relationship. Overfitting generally occurs when a model is excessively complex, such as having too many parameters relative to the number of observations.
Definition in Simpler Words
Curve fitting is the process of adapting a trading system so closely to historical data (which includes both noise and signals) that it becomes ineffective in the future.
Why is Curve Fitting Bad?
The past does not predict the future perfectly, especially in financial markets.
Adapting strategies too closely to past data will result in an inflexibility to adapt to the future. Hence, it leads to poor performance in the future.
What Does It Mean to Reduce Curve Fitting?
We need to adapt our trading strategies to signals in historical data, not noise.
Curve Fitting in Nature
The idea of curve fitting can be seen in nature. We shall use 3 animals as case studies to understand curve fitting in nature.
- I die easily…
Case 1: Giraffe (Curve Fitted)
Can only survive on land. Prefers leafy tall trees.
We consider giraffes as curve fitted animals. If we throw them into the ocean, they die. If we throw them into Antarctica, they die. If we remove leafy trees and just leave them with grass patches, they will find it difficult to survive.
Hence, the future of their environment needs to be similar to its past. If the giraffes’ environment starts changing aversely, they will be in trouble.
Case 2: Turtles (Reasonably Robust)
Can survive on land and water, but they are cold-blooded.
Turtles are much hardier creatures. However, the downside is that they are cold-blooded. Their body temperature relies on their surrounding environment. That said, these creatures can be considered reasonably robust. They can survive most changes in their environmental conditions.
Case 3: Tardigrade aka Water Bears (Extremely Robust)
Can survive in extreme temperatures [1 K (−458 °F; −272 °C) to about 420 K (300 °F; 150 °C)], pressure, radiation and outer space.
- Look at this cutie!
What kind of monster is this?! Tardigrades are tiny (1mm in length) but they are the hardiest animal on earth. Just a few days ago, I read that a tardigrade was brought back to life after being frozen for 30 years! And it gave birth to 14 healthy babies!
Tardigrades are extremely robust. They can survive almost anything that the future decides to throw at them. In general, we should design trading strategies in the same way that nature designs tardigrades.
Data-centric View of Curve Fitting
- Modelling data points.