Mechanical
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MechanicalTradingSystems
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MechanicalTradingSystemsPairing Trader Psychologywith Technical AnalysisRICHARD L. WEISSMANJohn Wiley & Sons, Inc.
Copyright 2005 by Richard L. Weissman. All rights reserved.CQG charts are copyright 2004 CQG, Inc. All rights reserved worldwide.Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in CanadaNo part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108 ofthe 1976 United States Copyright Act, without either the prior written permissionof the publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,978-750-8400, fax 978-646-8600, or on the Web at www.copyright.com. Requests tothe publisher for permission should be addressed to the Permissions Department,John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax201-748-6008.Limit of Liability/Disclaimer of Warranty: Although the publisher and author haveused their best efforts in preparing this book, they make no representations orwarranties with respect to the accuracy or completeness of the contents of thisbook and specifically disclaim any implied warranties of merchantability or fitnessfor a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained hereinmay not be suitable for your situation. You should consult with a professionalwhere appropriate. Neither the publisher nor author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.For general information on our other products and services, or technical support,please contact our Customer Care Department within the United States at 800-7622974, outside the United States at 317-572-3993, or fax 317-572-4002.Wiley also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic books.For more information about Wiley products, visit our web site at www.wiley.com.0-471-65435-3Printed in the United States of America10 9 8 7 6 5 4 3 2 1
For my wife, Pamela Nations-Weissman, whose vision inspiredthis manuscript, and also for my parents, whose belief and supportguided me through the early years
Every battle is won before it is ever fought.—Sun Tzu
ContentsCHAPTER 1PrefacexiiiAcknowledgmentsxixDispelling Myths and Defining Terms:Mathematical Technical Analysis andMechanical Trading Systems1Dispelling the Myths: The Inefficient Market and theHard Road to Profits1Technical Analysis: A Definition3Mechanical Trading Systems: A Definition5Defining the Time frames6Technical Analysis: Why it Works6Types of Technical Indicators: Trend-Following and MeanReversion10CHAPTER 2Mathematical Technical Analysis: A BuildingBlock for Mechanical Trading SystemDevelopment15Types of Technical Indicators16Trend-Following Indicators: Indicator-Driven Triggers18Price-Triggered Trend-Following Indicators: Donchian’sChannel BreakoutMean Reversion Indicator-Driven Triggers: Oscillators3031ix
xMECHANICAL TRADING SYSTEMSCHAPTER 3Trend-Following Systems: A Matterof Fortitude41Preliminary Considerations42Two Moving Average Crossover50Ichimoku Two Moving Average Crossover52Three Moving Average Crossover53Ichimoku Three Moving Average Crossover54MACD55DMI56DMI with ADX57Channel Breakout59Bollinger Bands60Some Comparisons61General Rules of Thumb63Cutting the Tails of a System’s Distribution65Psychological Profile of a Trend-Following Trader69CHAPTER 4Mean Reversion Systems:A Matter of Patience73Considerations in Analyzing Intermediate-Term MeanReversion Trading Systems73Trend-Following Mean Reversion Systems74Nondirectionally Biased Mean Reversion Systems81Psychological Profile of an Intermediate-Term Mean ReversionTraderCHAPTER 585Short-Term Systems: A Matter of QuickMindedness89Fading the Losing System89Liquidity and Volatility89Backtested Results91Swing Trading with 2-Hour Bars92Mean Reversion Systems Using 60-Minute Bars95Nondirectionally Biased Mean Reversion Systems96Mean Reversion Systems Using 30-Minute Bars98
xiContents15-Minute Bar Systems: RSI Extremes with 50-HourMoving Average Filter1015-Minute Bar Systems: RSI Extremes with 16.67-HourMoving Average FilterPsychological Profile of a Short-term TraderCHAPTER 6Knowing Oneself: How to ChallengeYour Knowledge101102105Trader Psychology: Ever the Same and Perpetually Changing105Time Frames, Trading Systems, and Personality Traits106CHAPTER 7System Development and Analysis:Benefits and Pitfalls115System Development Issues: An Overview115Benefits of Mechanical Trading Systems116Pitfalls of Mechanical Trading Systems116Optimization Process122System Development Process148Data Analysis Process151Trading System Philosophy Statements159Measuring Trading System Performance160CHAPTER 8Price Risk Management: Schools of PriceRisk Managment and OtherConsiderations163Price Risk Management Issues: An Overview163Stop-Loss Price Risk Management for Trading Accounts165Two Schools of Price Risk Management165Stop-Loss Price Risk Management166Volumetric Price Risk Management: Martingale andAnti-Martingale StrategiesValue at Risk: An Overview168169Benefits of Value at Risk170Pitfalls of Value at Risk171Stress Testing173
xiiMECHANICAL TRADING SYSTEMSPsychology of Price Risk Management173Mechanical Trading Systems, Drawdowns, andTrader ConfidenceCHAPTER 9Improving the Rate of Return: ImprovingReturns by Expanding the Comfort Zone174177Three Types of Diversification177Diversification of Parameter Sets177Mechanics of Trading System Diversification180Psychology of Trading System Diversification182CHAPTER 10 Discretion and Systems Trading:Discretion within a MechanicalFramework185Discretion and Paradigm Shifts185Discretion, Volatility, and Price Shocks186Mechanical Discretion187Pros and Cons of “True” Discretion188CHAPTER 11 Psychology of Mechanical Trading:Trading Systems and TransformationalPsychology189Discipline and Flexibility189Flexibility in Body and Mind191Knowing Ourselves192Single-mindedness: Unraveling the Onion Layers193Intuition versus the Psychic Trader Syndrome194Transformation via Adherence to MechanicalTrading SystemsTransformational Process: In Life and the Markets195196Notes199References and Further Reading205Index207
PrefaceIn 1987 my father and I purchased a seat on the New York Futures Exchangefor 100 and established a trading account with 25,000. The goal, he explained, was to make 2,500 a week. Although this seemed like an extraordinary annualized return on investment, I had heard of legendary traderswho had taken meager sums and transformed them into vast fortunes, andso I embarked on a journey that eventually culminated in the publication ofthis book.I wish I could tell you that this book contains the secrets of how I accomplished that formidable goal, but I never did learn how to consistentlyproduce even a 100 percent average annualized rate of return on my capital.I will say that if I had somehow accomplished that goal I would probablyhave very little knowledge to offer the typical trader. Instead my journeywas a difficult one in which I gradually learned that trying to earn severalhundred percent on my capital annually was, for me at least, a recipe for disaster.And yet if I had known what I now understand about realistic rates ofreturn on investment vis-à-vis risks taken to achieve those returns, I mightnot have chosen speculation as a career, and that path has given me farmore than mere financial rewards. It has taught me to be open-minded, patient, objective, consistent, disciplined, even-minded, and nonattached tothe results of my actions. In addition, it taught me how to survive as a traderwhile suffering from being severely undercapitalized.I am certain that there must be numerous practical methods accessibleto traders that allow them to produce respectable overall rates of return ontheir capital while minimizing the risk of ruin. However, to this day, theonly method that I have been able to impart successfully to professionaltraders is that of employing mechanical trading systems based on mathematical technical analysis. Such mechanical trading systems allow the development of comprehensive, detailed trading plans that include rules ofentry, exit, and price risk management. More important, they enable thebacktesting and forward testing of a particular strategy’s results prior toxiii
xivMECHANICAL TRADING SYSTEMSthe commitment of capital. This, in turn, aids in fostering the disciplinenecessary to weather the inevitable losses inherent in employment of anytrading program.This book will not show readers how to turn 10,000 into 1 million inone year’s time. I believe that system developers advocating their ability togenerate such rates of return are charlatans, victims of curve-fitted tradingsystems, or theoreticians blind to the risk of ruin entailed in the achievement of such spectacular returns. Instead of spectacular risks and returns,I offer simple trading systems that, because of that very simplicity, are quiterobust in terms of generating overall positive rates of return while simultaneously minimizing the risk of ruin. Although the proprietary strategies Ipersonally trade differ from those employed in this book, the systems offered herein are simple enough to have a significant probability of ensuringthe achievement of similar, moderately successful results in the future. Thatbeing said, the methodologies examined herein are certainly not intendedas “holy grails” of trading, but instead are offered as prototypes to motivateand guide readers in developing systems that match their individual temperaments.Critics of books on trading system development suggest that no onewould give away a successful trading system and that if a profitable systemwere given away, it would no longer work since everyone would be using it.Such criticism suggests a naivete regarding market dynamics and traderpsychology. This book argues that the primary reason for failure as a speculator is a lack of disciplined adherence to successful trading and price riskmanagement strategies as opposed to an inability to discover profitabletrading methodologies. The text shows that the development of rock-soliddiscipline is among the most challenging endeavors to which a trader canaspire. If this were not the case, anyone could master discipline and therewould be no financial rewards associated with successful speculation.When mechanical trading systems were first introduced into the arsenal of trading tools, traders interested in utilizing such tools would haveneeded programming expertise, a strong background in mathematical technical analysis, and iron-willed discipline. Over time, the trading system software developed by market data vendors has become simpler and more userfriendly, so that now nonprogrammers with only a rudimentary understanding of mathematical technical analysis can successfully create andbacktest simple trading systems such as those offered throughout this manuscript. It is for this reason that I have chosen to showcase CQG’s backtesting and optimization software as opposed to more “programmer-oriented”system development solutions.Although the primary intention of this book is to provide tools to aidrelative newcomers in quickly identifying their trading biases and shortcomings, the feedback I have received while presenting this material to
Prefacexvprofessional traders suggests that a detailed examination of the personalitytraits common to the three basic trader types—(long to intermediate term)trend-following, (intermediate-term) mean reversion, and short-term trading (swing and day traders)—along with a strict adherence to specific kindsof trading systems can foster a psychological flexibility that enables tradersto succeed in all kinds of trading environments: countertrending, choppy, ortrending. In addition, my hope is that the text proves valuable to institutional investors, affluent private investors, and others participating in investment vehicles that contain a systematic trading component.Through this framework of “reprogramming the trader,” the book examines the development process for mechanical trading systems. Thisprocess includes reasons for their popularity, the dangers in system development and how to avoid them, how backtesting and forward testing oftrading systems aids in quantification of price risk, and methods of improving rates of return on investment without significantly increasing risk.Throughout, I have striven to progress in a linear fashion from basic,rudimentary concepts to those of greater complexity. Nevertheless, in certain instances, to ensure both the reader’s comprehension of a particularconcept’s utility as well as to preserve the coherence and integrity of thematerial, I was forced to introduce ideas that traditionally would have beenincluded in later chapters. Wherever this was unavoidable, I have reiteratedthe concepts in the later chapters or referred the reader back to the earlierchapter.Chapter 1 defines mathematical technical analysis, distinguishes it fromclassical technical analysis, and shows the psychological reasons behindwhy it works. Then it explains why mathematical technical analysis is anideal building block in the development of mechanical trading systems asopposed to either fundamental analysis or interpretive technical analysis.Finally, the chapter dispels the myth of mechanical trading systems as aneasy method of generating profits.Chapter 2 looks at the two basic flavors of mathematical technical indicators: those attempting to capitalize on the market’s propensity towardmean reversion (i.e., oscillators), and indicators that profit from trendingprice activity (e.g., moving averages). The chapter then shows how technical indicators can be transformed into comprehensive trading systemsthrough the inclusion of various risk quantification parameters such asvolatility bands and percentage value of the trading instrument.Chapter 3 examines trend-following trading systems and shows howeven the most simplistic of systems can produce a respectable rate of returnwhile enduring relatively moderate worst peak-to-valley drawdowns in equity. It also discusses why certain asset classes tend to trend more than others and concludes with a detailed exposition of the personality traitsnecessary to succeed as a trend-following trader.
xviMECHANICAL TRADING SYSTEMSChapter 4 looks at simple intermediate-term mean reversion tradingsystems. It examines why certain asset classes display a greater propensitytoward mean reversion than others and includes examples of nondirectionally biased mean reversion systems and mean reversion systems that employ a trend-following filter. The chapter concludes with an exposition ofthe personality traits required for success as an intermediate-term mean reversion trader.Chapter 5 explores short-term—including swing and day trading—systems and the personality traits needed to succeed with these strategies. Aswith Chapters 3 and 4, the chapter examines backtested case studies andanalyzes the personality traits best suited for success with these strategies.Chapter 6 acts as a comprehensive review of the major categories oftrader types (trend-following, mean reversion) as well as the typical timeframes (long term, intermediate term, swing, and day trading) in which theyoperate. The chapter examines the various flaws in trader psychology—fearfulness, impatience, greed, lack of discipline, and so on, within the context of these personality types and trading time frames—then shows how toidentify these weaknesses by examining the trader’s personality traits andtrading style. Once readers have successfully identified their innate tradingpersonality, a step-by-step transformational process via utilization of different types of mechanical trading systems and psychological tools is outlined.Chapter 7 examines the many benefits offered by mechanical tradingsystems that have not been previously addressed. Then the text looks at thedownside to system development and how to resolve these problems: datacurve fitting, parameter curve fitting, data integrity issues, and underestimation of commissions and slippage. The chapter also examines the benefits and limitations of optimization studies, development of trading systemphilosophy statements, and the pros and cons of various methodologies formeasuring trading system performance.Chapter 8 discusses the pros and cons of various traditional price riskmanagement methods, such as stop loss and volumetric price risk management. Coverage of volumetric price risk includes both Martingale and antiMartingale position sizing techniques, such as fixed fractional positionsizing and value at risk. Other price risk management techniques coveredinclude the study of worst-backtested peak-to-valley equity drawdowns,“static” volumetric limits, stress testing and system stop losses as a percentage of total equity under management. Finally, the chapter examinesthe psychological aspects of price risk management and shows how utilization of mechanical trading systems can aid in fostering confidence duringdrawdowns.Chapter 9 looks at improving the overall rate of return through threemethods:
PrefacexviiThe addition of various low and/or negatively correlated assets, such ascrude oil and foreign exchange futures, into a single trading system2. The staggering of parameter set trigger levels for the same system3. The combination of mean reversion and trend-following systems withina single trading account or fund1.The chapter then concludes with an examination of the psychologicalbenefits gained through expansion beyond one’s “trading comfort zone.”Chapter 10 examines how a trader’s knowledge and experience can beutilized within the framework of a mechanical trading system. The pros andcons of increasing or decreasing position size among assets within a largetrading book—e.g., buying one E-mini S&P contract instead of 10—basedon various objectively quantifiable “discretionary” factors such as increasesin historical volatility, exceeding of worst peak-to-valley drawdowns in equity, and so on, as well as “fuzzier” discretionary elements, including contrary opinion, fundamental market analysis, and headline news events, arecovered in detail.Chapter 11 examines the link between mechanical trading systems andtransformational psychology, covering in detail issues such as self-worth,single-mindedness, discipline, nonattachment to the results of one’s actions,and recognition and releasing of old emotional patterns. The chapter concludes by examining skills mastered in the realm of trading and apply
0-471-65435-3 Printed in the United States of America . I am certain that there must be numerous practical methods accessible . as “holy grails” of trading, but instead are offered as prototypes to motivate and guide reade
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