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THE ENCYCLOPEDIA OF
TRADING STRATEGIES




JEFFREY OWEN KATZ, Ph.D.
DONNA 1. M C CORMICK
TRADEMARKS AND SERVICE MARKS




Company and product names associated with listings in this book should be con-
sidered as trademarks or service marks of the company indicated. The use of a reg-
istered trademark is not permitted for commercial purposes without the permission
of the company named. In some cases, products of one company are offered by
other companies and are presented in a number of different listings in this book. It
is virtually impossible to identify every trademark or service mark for every prod-
uct and every use, but we would like to highlight the following:

Visual Basic, Visual C++, and Excel are trademarks of Microsoft Corp.
NAG function library is a service mark of Numerical Algorithms Group, Ltd.
Numerical Recipes in C (book and software) is a service mark of Numerical
Recipes Software.
TradeStation, SuperCharts, and SystemWriter Plus are trademarks of
Omega Research.
Evolver is a trademark of Palisade Corporation.
Master Chartist is a trademark of Robert Slade, Inc.
TS-Evolve and TradeCycles (MESA) are trademarks of Ruggiero
Associates.
Divergengine is a service mark of Ruggiero Associates.
C++ Builder, Delphi, and Borland Database Engine are trademarks
of Borland.
CQC for Windows is a trademark of CQG, Inc.
Metastock is a trademark of Eqnis International.
technical analysis function library is a service mark of FM Labs.
Excalibur is a trademark of Futures Truth.
MATLAB is a trademark of The MathWorks, Inc.
MESA96 is a trademark of Mesa.
C ONTENTS
. ˜.




PREFACE xiii

INTRODUCTION xv
What Is a Complete Mechanical Trading System? - What Are Good Entries and Exits?
* The Scientific Approach to System Development * Tools and Materials Needed for
the Scientific Approach

PART I

Tools of the Trade
Introduction 1

Chapter 1

Data 3
Types of Data * Data Time Frames * Data Quality Data Sources and Vendors
l




Chapter 2
Simulators 13
Types of Simulators * Programming the Simulator * Simulator Output @erformance
summnry reports; trade-by-trade reports) * Simulator Perfomxmce (speed: capacity:
power) l Reliability of Simulators - Choosing the Right Simulator * Simulators Used
in This Book

Chaoter 3

Optimizers and Optimization 29
What Optimizers Do * How Optimizers Are Used * ?Lpes of Optimization (implicit
optimizers; brute force optimizers; user-guided optimization; genetic optimizers; optimization
by simulated annealing; analytic optimizers; linearpmgrwnming) How to Fail with
l

Optimization (small samples: large fxmztneter sets; no veri˜cation) . How to Succeed
with O&mization (h-ge, representative samples; few rules andparameters; veriicatim
@results) * Alternatives to Traditional Optimization * Optimizer Tools and Information *
Which Optimizer Is forYou?
Chapter 4
Statistics 51
Why Use Statistics to Evaluate Trading Systems? l Sampling * Optimization and
. Evaluating a System Statistically
Curve-Fitting l Sample Size and Representativeness
* Example 1: Evaluating the Out-of-Sample Test (what ifthe distribution is not normal?
what if there is serial dependence? what if the markets change?) l Example 2:
Evaluating the In-Sample Tests * Interpreting the Example Statistics (optimization
i-esults; verification results) l Other Statistical Techniques and Their Use (genetically
evoJved systems; multiple regression; monte car10 simulations; out-of-sample testing;
walk-forward testing) * Conclusion


PART II

The Study of Entries

Introduction 71
What Constitutes a Good Entry? * Orders Used in Entries (stop orders; limit orders;
market orders; selecting appropriate orders) * Entry Techniques Covered in This Book
(breakouts and moving averages; oscillators; seasonality: lunar and solar phenomena:
cycles and rhythms; neural networks; geneticaNy evolved entry rules) * Standardized
Exits * Equalization of Dollar Volatility * Basic Test Portfolio and Platfcnm

Chapter 5
Breakout Models 83
Kinds of Breakouts l Characteristics of Breakouts . Testing Breakout Models l
Channel Breakout Entries (close only channel breakouts; highest higMowest low
bnxzkouts) l Volatility Breakout Entries l Volatility Breakout Variations (long positions
only; currencies only; adx tremififilter) . Summary Analyses (breakout types: entry
orders; interactions; restrictions andjilters; analysis by market) * Conclusion l
What Have We Lamed?

Chapter 6
Moving Average Models 109
What is a Moving Average? - Purpose of a Moving Average * The Issue of Lag l
Types of Moving Averages l Types of Moving Average Entry Models l Characteristics
of Moving Average Entries l Orders Used to Effect Entries * Test Methodology ™
Tests of Trend-Following Models * Tests of Counter-Trend Models * Conclusion l
What Have We Learned?
ix


Chapter 7
Oscillator-Based Entries 133
What Is an Oscillator? l Kinds of Oscillators * Generating Entries with Oscillators *
Characteristics of Oscillator Entries . Test Methodology l Test Results (teas of
overbought/oversold models; tests of signal line models; tests of divergence models;
summary analyses) - Conclusion * What Have We Learned?

Chapter S
Seasonality 153
What Is Seasonality? l Generating Seasonal Entries l Characteristics of Seasonal
Entries . Orders Used to Effect Seasonal Entries . Test Methodology . Test Results
(test of the basic crossover model; tests of the basic momentum model: tests of the
crossover model with con$mtion; tests of the C˜SSOV˜˜ model with confirmation and
inversions: summary analyses) * Conclusion * What Have We Learned?

Chmter 9
Lunar and Solar Rhythms 179
Legitimacy or Lunacy? l Lunar Cycles and Trading (generating lunar entries: lunar test
methodology; lunar test results; tests of the basic cmmo˜er model; tests of the basic
momentum model: tests of the cnx˜mer model with confirmation; test.s of the crmmver
model with confirmation and inversions; summary analyses; conclusion) * Solar
Activity and Trading (generazing solar entries: solar test results: conclusion) *
What Have We Learned?

Chapter 10

Cycle-Based Entries 2Q3
Cycle Detection Using MESA l Detecting Cycles Using Filter Banks (butterworth
jilters; wavelet-basedjilters) * Generating Cycle Entries Using Filter Banks *
Characteristics of Cycle-Based Entries . Test Methodology . Test Results .
Conclusion l What Have We Learned?

Chapter 11
Neural Networks 227
What Are Neural Networks? (feed-forward neural networks) . Neural Networks
in Trading l Forecasting with Neural Networks l Generating Entries with Neural
Predictions . Reverse Slow %K Model (code for the reverse slow % k model: test
methodology for the reverse slow % k model; training results for the reverse slow %k
model) l Turning Point Models (code for the turning point models; test methodology
for the turning point models; training resulrs for the turning point models) * Trading
Results for All Models (@ading results for the reverse slow %k model: frading results
for the bottom ruming point model; trading results for the top turning poinf model) *
Summary Analyses l Conclusion * What Have We Learned?

Chapter 12
Genetic Algorithms 257
What Are Genetic Algorithms? * Evolving Rule-Based Entry Models * Evolving an
Entry Model @he rule remplares) * Test Methodology (code for evolving an entry
model) l Test Results (solutions evolved for long entries; solutions evolved for short
enrries; fesf results for the standard portfolio; market-by-market tesf resulrs: equify
curves; the rules for rhe solurions tesred) * Conclusion * What Have We Learned?

PART III

The Study of Exits

Introduction 281
The Importance of the Exit l Goals of a Good Exit Strategy * Kinds of Exits
Employed in an Exit Strategy (money management exits; trailing exits; projir tnrgef
exiW rime-based exits; volarilify airs: barrier exits; signal exits) * Considerations
When Exiting the Market (gunning; trade-offs with prorecrive stops: slippage;
conC?nian rrading: conclusion) * Testing Exit Strategies * Standard Entries for Testing
Exits (the random entry model)

Chaoter 13
The Standard Exit Strategy 293
What is the Standard Exit Strategy? * Characteristics of the Standard Exit * Purpose of
Testing the SES l Tests of the Original SES (test results) * Tests of the Modified SES
(test resulrs) * Conclusion - What Have We Learned?

Chapter 14
Improvements on the Standard Exit 309
Purpose of the Tests l Tests of the Fixed Stop and Profit Target * Tests of Dynamic
Stops (rest of the highest higWlowest low stop; fesf of the dynamic arr-based stop: fat
of the modified exponential moving average dynamic stop) * Tests of the Profit Taget *
Test of the Extended Time Limit - Market-By-Market Results for the Best Exit *
Conclusion l What Have We Learned?
xi


Chapter 15

Adding Artificial Intelligence to Exits 335
Test Methodology for the Neural Exit Component . Results of the Neural Exit Test
(baseline results; neural exit portjolio results: neural exit market-by-market results) .
Test Methodology for the Genetic Exit Component (top 10 solutions with baseline exit:
results of rule-based exits for longs and shorts; market-by-market resu1t.s (If rule-based
exits for longs: market-by-market results
PREFACE




I n this book is the knowledge needed to become a mc˜re successful trader of com-
modities. As a comprehensive reference and system developer™s guide, the book
explains many popular techniques and puts them to the test, and explores innova-
tive ways to take profits out of the market and to gain an extra edge. As well, the
book provides better methods for controlling risk, and gives insight into which
methods perform poorly and could devastate capital. Even the basics are covered:
information on how to acquire and screen data, how to properly back-test systems
using trading simulators, how to safely perform optimization, how to estimate and
compensate for curve-fitting, and even how to assess the results using inferential
statistics. This book demonstrates why the surest way to success in trading is
through use of a good, mechanized trading system.
For all but a few traders, system trading yields mm-e profitable results than
discretionary trading. Discretionary trading involves subjective decisions that fre-
quently become emotional and lead to losses. Affect, uncertainty, greed, and fear
easily displace reason and knowledge as the driving forces behind the trades.
Moreover, it is hard to test and verify a discretionary trading model. System-
based trading, in contrast, is objective. Emotions are out of the picture. Through
programmed logic and assumptions, mechanized systems express the trader™s
reason and knowledge. Best of all, such systems are easily tested: Bad systems
can be rejected or modified, and good cntes can be improved. This book contains
solid information that can be of great help when designing, building, and testing
a profitable mechanical trading system. While the emphasis is on an in-depth,
critical analysis of the various factors purported to contribute to winning systems,
the essential elements of a complete, mechanical trading system are also dissected
and explained.
To be complete, all mechanical trading systems must have an entry method
and an exit method. The entry method must detect opportunities to enter the mar-
ket at points that are likely to yield trades with a good risk-to-reward ratio. The
exit method must protect against excessive loss of capital when a trade goes wrong
or when the market turns, as well as effectively capture profits when the market
moves favorably. A considerable amount of space is devoted to the systematic
back-testing and evaluation of exit systems, methods, and strategies. Even the
trader who already has a trading strategy or system that provides acceptable exits
is likely to discover something that can be used to improve the system, increase
profits, and reduce risk exposure.
Also included in these pages are trading simulations on entire pqrtfolios of
tradables. As is demonstrated, running analyses on portfolios is straightforward, if
not easy to accomplish. The ease of computing equity growth curves, maximum
drawdowns, risk-to-reward ratios, returns on accounts, numbers of trades, and all
xiv PREFACE




the other related kinds of information useful in assessing a trading system on a
whole portfolio of commodities or stocks at once is made evident. The process of
conducting portfolio-wide walk-forward and other forms of testing and optimiza-
tion is also described. For example, instruction is provided on how to search for a
set of parameters that, when plugged into a system used to trade each of a set of
commodities, yields the best total net profit with the lowest drawdown (or perhaps
the best Sharpe Ratio, or any other measure of portfolio performance desired) for
that entire set of commodities. Small institutional traders (CTAs) wishing to run a
system on multiple tradables, as a means of diversification, risk reduction, and liq-
uidity enhancement, should find this discussion especially useful.
Finally, to keep all aspects of the systems and components being tested
objective and completely mechanical, we have drawn upon our academic and sci-
entific research backgrounds to apply the scientific method to the study of entry
and exit techniques. In addition, when appropriate, statistics are used to assess
the significance of the results of the investigations. This approach should provide the
most rigorous information possible about what constitutes a valid and useful com-
ponent in a successful trading strategy.
So that everyone will benefit from the investigations, the exact logic behind
every entry or exit strategy is discussed in detail. For those wishing to replicate
and expand the studies contained herein, extensive source code is also provided in
the text, as well as on a CD-ROM (see offer at back of book).
Since a basic trading system is always composed of two components, this
book naturally includes the following two parts: “The Study of Entries” and “The
Study of Exits.” Discussions of particular technologies that may be used in gener-
ating entries or exits, e.g., neural networks, are handled within the context of devel-
oping particular entry or exit strategies. The “Introduction” contains lessons on the
fundamental issues surrounding the implementation of the scientific approach to
trading system development. The first part of this book, “Tools of the Trade,” con-
tains basic information, necessary for all system traders. The “Conclusion” pro-
vides a summary of the research findings, with suggestions on how to best apply
the knowledge and for future research. The ˜Appendix” contains references and
suggested reading.
Finally, we would like to point out that this book is a continuation and elab-
oration of a series of articles we published as Contributing Writers to Technical
Analysis of Stocks and Commodities from 1996, onward.

Jeffrey Owen Katz, Ph.D., and Donna L. McCormick
INTRODUCTION




There is one thing that most traders have in common: They have taken on the
challenge of forecasting and trading the financial markets, of searching for those
small islands of lucrative inefficiency in a vast sea of efficient market behavior.
For one of the authors, Jeffrey Katz, this challenge was initially a means to indulge
an obsession with mathematics. Over a decade ago, he developed a model that pro-
vided entry signals for the Standard & Poor™s 500 (S&P 500) and OEX. While
these signals were, at that time, about 80% accurate, Katz found himself second-
guessing them. Moreover, he had to rely on his own subjective determinations of
such critical factors as what kind of order to use for entry, when to exit, and where
to place stops. These determinations, the essence of discretionary trading, were
often driven more by the emotions of fear and avarice than by reason and knowl-
edge. As a result, he churned and vacillated, made bad decisions, and lost more
often than won. For Katz, like for most traders, discretionary trading did not work.
If discretionary trading did not work, then what did? Perhaps system trading
was the answer. Katz decided to develop a completely automated trading system
in the form of a computer program that could generate buy, sell, stop, and other
necessary orders without human judgment or intervention. A good mechanical
system, logic suggested, would avoid the problems associated with discretionary
trading, if the discipline to follow it could be mustered. Such a system would pro-
vide explicit and well-defined entries, “normal” or profitable exits, and “abnor-
mal” or money management exits designed to control losses on bad trades,
A fully automated system would also make it possible to conduct historical
tests, unbiased by hindsight, and to do such tests on large quantities of data.
Thorough testing was the only way to determine whether a system really worked
and would be profitable to trade, Katz reasoned. Due to familiarity with the data
series, valid tests could not be performed by eye. If Katz looked at a chart and
“believed” a given formation signaled a good place to enter the market, he could
not trust that belief because he had already seen what happened after the forma-
tion occurred. Moreover, if charts of previous years were examined to find other
examples of the formation, attempts to identify the pattern by “eyeballing” would
be biased. On the other hand, if the pattern to be tested could be formally defined
and explicitly coded, the computer could then objectively do all the work: It
would run the code on many years of historical data, look for the specified for-
mation, and evaluate (without hindsight) the behavior of the market after each
instance. In this way, the computer could indicate whether he was indeed correct in
his hypothesis that a given formation was a profitable one. Exit rules could also
be evaluated objectively.
Finally, a well-defined mechanical trading system would allow such things
as commissions, slippage, impossible tills, and markets that moved before he
xvi


could to be factored in. This would help avoid unpleasant shocks when moving
from computer simulations to real-world trading. One of the problems Katz had in
his earlier trading attempt was failing to consider the high transaction costs
involved in trading OEX options. Through complete mechanization, he could
ensure that the system tests would include all such factors. In this way, potential
surprises could be eliminated, and a very realistic assessment could be obtained of
how any system or system element would perform. System trading might, he
thought, be the key to greater success in the markets.

WHAT IS A COMPLETE, MECHANICAL TRADING SYSTEM?
One of the problems witb Katz™s early trading was that his “system” only provided
entry signals, leaving the determination of exits to subjective judgment; it was not,
therefore, a complete, mechanical trading system. A complete, mechanical trading
system, one that can be tested and deployed in a totally objective fashion, without
requiring human judgment, must provide both entries and exits. To be truly com-
plete, a mechanical system must explicitly provide the following information:
1. When and how, and possibly at what price, to enter the market
2. When and how, and possibly at what price, to exit the market with a loss
3. When and how, and possibly at what price, to exit the market with
a profit
The entry signals of a mechanical trading system can be as simple as explic-
it orders to buy or sell at the next day™s open. The orders might be slightly more
elaborate, e.g., to enter tomorrow (or on the next bar) using either a limit or stop.
Then again, very complex contingent orders, which are executed during certain
periods only if specified conditions are met, may be required-for example, orders
to buy or sell the market on a stop if the market gaps up or down more than so
many points at the open.
A trading system™s exits may also be implemented using any of a range of
orders, from the simple to the complex. Exiting a bad trade at a loss is frequently
achieved using a money management stop, which tertninates the trade that has
gone wrong before the loss becomes seriously damaging. A money management
stop, which is simply a stop order employed to prevent runaway losses, performs
one of the functions that must be achieved in some manner by a system™s exit strat-
egy; the function is that of risk control. Exiting on a profit may be accomplished
in any of several different ways, including by the use of pm@ targets, which are
simply limit orders placed in such a way that they end the trade once the market
moves a certain amount in the trader™s favor; trailing stops, which are stop orders
used to exit with a profit when the market begins to reverse direction; and a wide
variety of other orders or combinations of orders.
In Katz™s early trading attempts, the only signals available were of probable
direction or turning points. These signals were responded to by placing buy-at-
market or sell-at-market orders, orders that are often associated with poor fills and
lots of slippage. Although the signals were often accurate, not every turning point
was caught. Therefore, Katz could not simply reverse his position at each signal.
Separate exits were necessary. The software Katz was using only served as a par-
tially mechanical entry model; i.e., it did not provide exit signals. As such, it was
not a complete mechanical trading system that provided both entries and exits.
Since there were no mechanically generated exit signals, all exits had to be deter-
mined subjectively, which was one of the factors responsible for his trading prob-
lems at that time. Another factor that contributed to his lack of success was the
inability to properly assess, in a rigorous and objective manner, the behavior of the
trading regime over a sufficiently long period of historical data. He had been fly-
ing blind! Without having a complete system, that is, exits as well as entries, not
to mention good system-testing software, how could such things as net profitabil-
ity, maximum drawdown, or the Sharpe Ratio be estimated, the historical equity
curve be studied, and other important characteristics of the system (such as the
likelihood of its being profitable in the future) be investigated? To do these things,
it became clear-a system was needed that completed the full circle, providing

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