What is Incubation?
Incubation is another form of out of sample testing that deals with many the shortcomings of typical out of sample testing. It is a great tool that can save you from trading many strategies that would incur losses if traded live!
The concept is very simple:
Once you have found an edge that you believe will hold going forward, you wait some time to see how it performs on future data, thus removing any biases.
The advantages of this method are enormous:
- When testing your edge with future data, there is no way of going back and forth between in sample and out of sample data. You will have to wait another 6 months or whatever incubation period you set, if you tweak your strategy again.
- Your biases will not be able to trick you into creating curve fit models. Future data is unseen and cannot be taken into consideration when creating strategies.
- While curve fitting is avoided, another danger that is mitigated through incubation, is over confidence. Once we have created a strategy, we have put a lot of time and effort into that very strategy. A lot of feelings become involved and quite often we overestimate its greatness and potential. With incubation, we let time pass, and once it is time to trade a strategy our feelings have abated. In other words, you become a more rational decisionmaker.
Despite being a great tool to prevent curve fitting, there are two main drawbacks to this method:
- The first one is that it takes time. If you create something today, it will take a long time before you can start trading it live.
- The second drawback is the same as applies to every other out of sample testing method. Your edge could be just be lucky and survive your incubation despite being curve fit.
Despite the drawbacks, incubation should be part of every trader’s toolbox. The advantages of incubating what you have created are enormous. However, most probably you need to see it yourself to fully understand its value. That is why we encourage you to implement it in your trading process right after reading this article!
Trust us! You will thank us later!