While reading I am coming upon the term Objective Function. I understand that this relates to profitability, however I am unclear as to when the term is used is it generally referring to the specific Code and Parameters that undergird the rules for my trading formula. Or is it referring to a different aspect of my trading system? Higher mathematics is not my strong suit, although I anticipate learning what is pertinent to successfully building and trading a quantitative trading system.
Thank you for your patience with an undereducated newbie.
@Floridafan, if you have not read the books written by @howardbandy, those would be a great place to start when it comes to understanding Objective Functions. At a high level, your Objective Function is a calculation that measures how well a particular strategy (or strategy variation) has achieved your objective. If your objective is to make as much money as possible without regard to drawdowns, volatility, etc. then your OF could be something as simple as Compound Annual Return. If you care about smooth returns and outperforming some benchmark like the risk-free rate of return, then you might use the Sharpe Ratio as your OF. And of course, you could define your very own function that provides a numeric value for the "goodness" of your strategy.
One place that you will see the OF being used is in walk-forward testing, in which you optimize across a particular set of variables for a fixed period of time. At the end of each In-Sample time period, you have to select one of the optimized variations to use for the next Out-Of-Sample time period. The variation that you select will be determined by the OF that you choose to use.
2 Likes