Beyond Technical Analysis Beyond Technical Analysis: How to Develop and Implement a Winning Trading System Tushar S. Chande, PhD John Wiley 61 Sons, Inc. New York • Chichester • Brisbane • Toronto • Singapore • Weinheim This text is printed on acid-free paper. Copyright © 1997 by Tushar S.
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If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Library of Congress Cataloging in Publicaton Data: Chande, Tushar S., 1958- Beyond technical analysis : how to develop & implement a winning trading system / Tushar S. ISBN 0-471-16188-8 (cloth : alk.6—dc20 96-34436 Printed in the United States of America 10 98765432 Contents Preface xi Acknowledgments xiii 1 Developing and Implementing Trading Systems 1 Introduction 1 The Usual Disclaimer 3 What Is a Trading System? 3 Comparison: Discretionary versus Mechanical System Trader 4 Why Should You Use a Trading System? 5 Robust Trading Systems: TOPS COLA 6 How Do You Implement a Trading System? 7 Who Wins? Who Loses? 8 Beyond Technical Analysis 9 2 Principles of Trading System Design 11 Introduction 11 What Are Your Trading Beliefs? 12 Six Cardinal Rules 14 Rule 1: Positive Expectation 15 Rule 2: A Small Number of Rules 17 viii Contents Rule 3: Robust Trading Rules 22 Rule 4: Trading Multiple Contracts 29 Rule 5: Risk Control, Money Management, and Portfolio Design 32 Rule 6: Fully Mechanical System 36 Summary 37 3 Foundations of System Design 39 Introduction 39 Diagnosing Market Trends 40 To Follow the Trend or Not? 44 To Optimize or Not to Optimize? 48 Initial Stop: Solution or Problem? 52 Does Your Design Control Risks? 60 Data! Handle with Care! 64 Choosing Orders for Entries and Exits 66 Understanding Summary of Test Results 67 What the Performance Summary Does Not Show 70 A Reality Check 71 4 Developing New Trading Systems 73 Introduction 73 The Assumptions behind Trend- Following Systems 74 The 65sma-3cc Trend-Following System 75 Effect of Initial Money Management Stop 88 Adding Filter to the 65sma-3cc System 93 Adding Exit Rules to the 65sma- 3cc System 99 Channel Breakout-Pull Back Pattern 101 An ADX Burst Trend-Seeking System 111 A Trend-Antitrend Trading System 116 Gold-Bond Intermarket System 123 A Pattern for Bottom-Fishing 132 Contents ix Identifying Extraordinary Opportunities 140 Summary 144 5 Developing Trading System Variations 147 Introduction 147 Channel Breakout on Close with Trailing Stops 149 Channel Breakout on Close with Volatility Exit 152 Channel Breakout with 20-Tick Barrier 155 Channel Breakout System with Inside Volatility Barrier 159 Statistical Significance of Channel Breakout Variations 161 Two ADX Variations 165 The Pullback System 168 The Long Bomb — A Pattern-based System 173 Summary 177 6 Equity Curve Analysis 179 Introduction 179 Measuring the "Smoothness" of the Equity Curve 180 Effect of Exits and Portfolio Strategies on Equity Curves 186 Analysis of Monthly Equity Changes 194 Effect of Filtering on the Equity Curve 200 Summary 204 7 Ideas for Money Management 207 Introduction 207 The Risk of Ruin 208 Interaction: System Design and Money Management 212 Projecting Drawdowns 218 Changing Bet Size after Winning or Losing 221 Summary 224 x Contents 8 Data Scrambling 227 Introduction 227 What You Really Want to Know about Your System 227 Past Is Prolog: Sampling with Replacement 229 Data Scrambling: All the Synthetic Data You'll Ever Need 231 Testing a Volatility System on Synthetic Data 236 Summary 239 9 A System for Trading 241 Introduction 241 The Problem with Testing 242 Paper Trading: Pros and Cons 242 Do You Believe in Your System? 243 Time Is Your Ally 244 No Exceptions 245 Full Traceability 245 "Guaranteed" Entry into Major Trends 246 Starting Up 247 Risk Control 248 Do You Have a Plan? 248 How Will You Monitor Compliance? 249 Get It Off Your Chest! 249 Focus on Your Trading 250 Trading with Your Head and Heart 250 Summary 252 Selected Bibliography 253 Index 255 About the Disk 261 Preface This is a book about designing, testing, and implementing trading sys- tems for the futures and equities markets. The book begins by develop- ing trading systems and ends by defining a system for trading.
It focuses exclusively on trading systems. Hence, I have assumed that the reader has at least a working knowledge of technical analysis and is familiar with software for developing technical trading systems The book is broadly divided into two parts. The first half deals with development and testing—how the system worked on past data— and discusses basic rules, key issues, and many new systems. The second half explores how the system might do in the future, with a focus on equity curves, risk control, and money management.
A key contribution is a new method called "data scrambling," which allows unlimited amounts of synthetic data to be generated for true out-of- sample testing. The last chapter brings all of the material together by offering solutions to practical problems encountered in implementing a trading system. This book goes beyond technical analysis—it bridges the gap be- tween analysis and trading. It provides a comprehensive treatment of trading systems, and offers a stimulating mix of new ideas, timeless principles, and practical guidelines to help you develop trading systems that work.
Acknowledgments I thank Nelson F. Freeburg for twice reading this manuscript. Nelson's meticulous attention to detail, outstanding grasp of the subject, sharp eye for inconsistencies, and love of the language have helped to improve this book immeasurably. Nelson edits a monthly newsletter, Formula Research, which is "must-reading" for serious students of the financial markets.
A good editor is essential to guide a book to completion. I want to thank Pamela Van Giessen of John Wiley & Sons for being the accessible, cheerful, and resourceful editor every author loves. Beyond Technical Analysis Chapter Developing and Implementing Trading Systems Nothing is easier than developing a trading system by the •usual process of trial and terror. Development of trading system variations, which discusses eight variations of known ideas Once you have read the first half, you will be eager to explore questions about system implementation.
The second half of the book is organized as follows: 5. Equity curve analysis, which explores what influences equity curve smoothness 6. Ideas for money management, which is the starting point for risk control 7. Data scrambling, which offers all the synthetic data you will ever need 8.
A system for trading, which presents solutions to practical problems After reading this volume, you should be able to take your ideas and convert them into useful trading systems. This book develops deterministic trading systems, which means that all the rules can be explicitly evaluated. The book does not discuss trading systems based on expert systems, neural networks, or fuzzy logic for two simple but important reasons: (1) More users understand and easily implement deterministic systems than any other type of system. (2) The software for testing deterministic systems is widely available at an economical price.
Put the two together, and this book becomes immediately accessible to a large audience. What Is a Trading System? The Usual Disclaimer Throughout the book, a number of trading systems are explored as ex- amples of the art of designing and testing trading systems. This is not a recommendation that you trade these systems. I do not claim that these systems will be profitable in the future, nor that profits or losses will be similar to those shown in the calculations.
In fact, there is no guarantee that these calculations are defect free. I urge you to review the section in chapter 3 called a reality check. That section points out the inherent limitations of developing systems with the benefit of hindsight. You should use the examples in this book as an inspiration to develop your own trading systems.
Do not forget that there is risk of loss in futures trading. What Is a Trading System? A trading system is a set of rules that defines conditions required to in- itiate and exit a trade. Usually, most trading systems have many parts, such as entry, exit, risk control, and money management rules. The rules of a trading system can be implicit or explicit, simple or complex.
A system can be as simple as "buy sweaters in summer," or "buy when she sells." By definition, the system must be feasible. Ideally, the system accounts for "all" trading issues, from signal generation, to order placement, to risk control. A good way to visualize effective system design is to stipulate that someone who is not a trader must be able to implement the system. In practice, every trader uses a system.
For most traders, a system could really be many systems. It could be discretionary, partly discretionary, or folly mechanical. The systems could use different types of data, such as 5-minute bars or weekly data. The systems may be neither consistent nor easy to test; the rules could have many exceptions.
A system could have many variables and parameters. You can trade different combinations of parameters on the same market. You can trade different parameter sets on different markets. You can even trade the same parameter set on all markets.
It should be clear by now that there is no single universal trading system. Every trader adapts a "system" to his or her style of trading. However, it is possible to draw a distinction between a discretionary trader and a 100% mechanical system trader, as compared in the next section. 4 Developing and Implementing Trading Systems Comparison: Discretionary versus Mechanical System Trader Table 1.1 compares two extremes in trading: a discretionary trader and a 100% mechanical system trader.
Discretionary traders use all inputs that seem relevant to the trade: fundamental data, technical analysis, news, trade press, phases of the moon—their imagination is the limit. System traders, on the other hand, slavishly follow a mechanical system without any deviations. Their entire focus is on implementing the system "as is," with no variations, exceptions, modifications, or adaptations of any kind. Exceptional traders are discretionary traders, and they can prob- ably outperform all mechanical system traders.
Their biggest advantage is that they can change the key variable driving each trade, and therefore vary bet size more intelligently than in a mechanical system. Discretionary traders can change the relative importance of their trading variables so they can easily switch between trend- following and anti-trend modes. They can instantly switch between time frames of analysis, going from 5-minute bars to weekly bars as their assessment of the trading opportunity changes. Discretionary traders can make better use of market information other than price.
For example, they can react to news or fundamental information to change bet size. Discretionary traders can adjust their perceived risk constantly, so they can increase or decrease positions more intelligently than mechanical traders. These infrequent "home runs" often make all the difference between good and great trading performance. However, for the average trader, being a mechanical system trader probably maximizes the chances of success.
The goals of a mechanical system trader are to pick a time frame (for example, hourly, daily, weekly), identify the trend status, and anticipate the direction of the future trend.
