Deflated Sharpe & the multiple testing tax
The more strategies you try, the better your best one looks, for reasons that have nothing to do with skill. The Deflated Sharpe Ratio puts a number on that penalty.
Selection inflates the winner
Flip enough coins and one 'lucky' coin will land heads ten times in a row. Backtest enough variations and one will post a gorgeous Sharpe by chance alone. Reporting only the winner, without counting the losers you discarded, is how backtests lie.
The Deflated Sharpe discounts the search
The Deflated Sharpe Ratio adjusts a strategy's Sharpe down based on how many trials it took to find it and how noisy those returns were. It answers the honest question: given everything I tried, what's the chance this edge is real?
Count every trial
The tax only works if you're honest about the trial count. Every tweak to the RSI level, every timeframe you tried, every asset you swapped in is a trial. Run this, then open Robustness and Parameter sensitivity (on Power and above), and note how the raw Sharpe and the Deflated Sharpe diverge as the recorded trials pile up.
Run it live
The strategy for this lesson, in plain English:
“Buy SOL when RSI crosses above 55 on the 4 hour chart; exit when RSI falls below 45, last 3 years.”
It opens already parsed, so you can read the rules before you spend a run.
Key takeaway
Your edge is the Deflated Sharpe, not the raw one. If it survives being discounted for every idea you tried, it's worth taking seriously.
Terms in this lesson
Check yourself