New Trading Systems and Methods by Perry Kaufman

924 Pages·2012·36.83 MB·English

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Contents
L
A
I
R
E
T
Preface 8
A
M
CHAPTER 1 Introduction 13

The Expanding Role of TeDchnical Analysis 14
Convergence of Trading Styles in Stocks and Futures 15
E
A Line in the Sand between Fundamentals and Technicals 16
T
Professional and Amateur 17
Random Walk H 18
Background Material 20
G
Research Skills 22
Objectives oIf This Book 23
R
Profile of a Trading System 24
A Word aYbout the Notation Used in This Book 27
P
CHAPTER 2 Basic Concepts 28
O
About Data and Averaging 29
On Average 32
C
Price Distribution 36
Dispersion, Skewness, and Kurtosis 40
Standardizing Returns and Risk 49
The Index 53
Probability 56
Supply and Demand 62
CHAPTER 3 Charting 69
Finding Consistent Patterns 70
What Creates the Major Price Moves and Trends? 72
The Bar Chart and Its Interpretation by Charles Dow 73
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CONTENTS
Chart Formations 80
Trendlines 82
One-Day Patterns 87
Continuation Patterns 94
Basic Concepts in Chart Trading 97
Accumulation and Distribution—Bottoms and Tops 98
Episodic Patterns 110
Price Objectives for Bar-Charting 112
Implied Strategies in Candlestick Charts 116
Practical Use of the Bar Chart 120
Evolution in Price Patterns 123
CHAPTER 4 Charting Systems and Techniques 125
Dunnigan and the Thrust Method 126
Nofri's Congestion-Phase System 129
Outside Days with an Outside Close 130
Action and Reaction 131
Channel Breakout 137
Moving Channels 140
Combining Techniques 142
Complex Patterns 143
A Study of Charting Patterns 146
CHAPTER 5 Event-Driven Trends 148
Swing Trading 149
Constructing a Swing Chart Using a Swing Filter 151
Point-and-Figure Charting 159
The N-Day Breakout 180
CHAPTER 6 Regression Analysis 184
Components of a Time Series 184
Characteristics of the Price Data 185
Linear Regression 186
Linear Correlation 194
Nonlinear Approximations for Two Variables 198
Second-Order Least Squares 200
Transforming Nonlinear to Linear 202
Evaluation of Two-Variable Techniques 205
Multivariate Approximations 207
ARIMA 212
Basic Trading Signals Using a Linear Regression Model 217
Measuring Market Strength 221
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Contents
CHAPTER 7 Time-Based Trend Calculations 223
Forecasting and Following 224
The Moving Average 229
Geometric Moving Average 240
Drop-Off Effect 241
Exponential Smoothing 242
Relating Exponential and Standard Moving Averages 250
CHAPTER 8 Time-Based Trend Systems 256
Why Trend Systems Work 256
Basic Buy and Sell Signals 259
Bands and Channels 263
Applications of Single Trends 268
Comparison of Major Trend Systems 273
Techniques Using Two Trendlines 289
More than Two Trends 292
Comprehensive Studies 293
Selecting the Right Moving Average 294
Moving Average Sequences: Signal Progression 297
Living with a Trend-Following Philosophy 300
CHAPTER 9 Momentum and Oscillators 303
Momentum 305
Oscillators 315
Double-Smoothed Momentum 326
Velocity and Acceleration 331
Hybrid Momentum Techniques 335
Momentum Divergence 338
Some Final Comments on Momentum 345
CHAPTER 10 Seasonality 346
A Consistent Factor 347
The Seasonal Pattern 348
Popular Methods for Calculating Seasonality 349
Seasonal Filters 365
Seasonality and the Stock Market 369
Common Sense and Seasonality 372
CHAPTER 11 Cycle Analysis 373
Cycle Basics 374
Uncovering the Cycle 380
Maximum Entropy 397
Cycle Channel Index 403
Phasing 404
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CONTENTS
CHAPTER 12 Volume, Open Interest, and Breadth 407
A Special Case for Futures Volume 408
Variations from the Normal Patterns 409
Standard Interpretation 412
Volume Indicators 415
Breadth Indicators 423
Interpreting Volume and Breadth Systematically 426
An Integrated Probability Model 428
Intraday Volume Patterns 429
Filtering Low Volume 431
Market Facilitation Index 433
CHAPTER 13 Spreads and Arbitrage 434
Dynamics of Futures Intramarket Spreads 435
Spreads in Stocks 437
Spread and Arbitrage Relationships 438
Risk Reduction in Spreads 439
Arbitrage 440
Carrying Charges 452
Changing Spread Relationships 454
Intermarket Spreads 458
Technical Analysis of Spreads 461
Leverage in Spreads 468
CHAPTER 14 Behavioral Techniques 469
Measuring the News 470
Event Trading 474
Commitment of Traders Report 481
Opinion and Contrary Opinion 486
Fibonacci and Human Behavior 491
Elliott's Wave Principle 494
Price Target Constructions Using the Fibonacci Ratio 503
Fischer's Golden Section Compass System 506
W. D. Gann—Time and Space 510
Financial Astrology 514
CHAPTER 15 Pattern Recognition 523
Projecting Daily Highs and Lows 525
Time of Day 527
Opening Gaps and Intraday Patterns 541
Three Studies in Market Movement—Weekday,
Weekend, and Reversal Patterns 550
Computer-Based Pattern Recognition 570
Artificial Intelligence Methods 573
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Contents
CHAPTER 16 Day Trading 574
Impact of Transaction Costs 575
Applicability of Trading Techniques 580
Trading Using Price Patterns 584
CHAPTER 17 Adaptive Techniques 593
Adaptive Trend Calculations 593
Adaptive Momentum Calculations 602
Adaptive Intraday Breakout System 604
An Adaptive Process 605
Considering Adaptive Methods 606
CHAPTER 18 Price Distribution Systems 607
Measuring Distribution 607
Use of Price Distributions and Patterns
to Anticipate Moves 609
Distribution of Prices 612
Steidlmayer’s Market Profile 620
CHAPTER 19 Multiple Time Frames 626
Tuning Two Time Frames to Work Together 627
Elder’s Triple-Screen Trading System 628
Robert Krausz’s Multiple Time Frames 630
Martin Pring’s KST System 633
CHAPTER 20 Advanced Techniques 636
Measuring Volatility 636
Trade Selection 650
Price-Volume Distribution 652
Trends and Noise 654
Expert Systems 658
Fuzzy Logic 661
Fractals, Chaos, and Entropy 665
Neural Networks 670
Genetic Algorithms 677
Considering Genetic Algorithms, Neural Networks,
and Feedback 682
CHAPTER 21 System Testing 683
Expectations 685
Identifying the Parameters 687
Selecting the Test Data 689
Searching for the Optimal Result 693
Visualizing and Interpreting Test Results 695
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Step-Forward Testing and Out-of-Sample Data 703
Massive Testing 705
Changing the Strategy Rules 708
Arriving at Valid Test Results 709
Point-and-Figure Testing 716
Comparing the Results of Two Systems 719
Profiting from the Worst Results 725
Retesting Procedure 728
Comprehensive Studies 731
Price Shocks 744
Anatomy of an Optimization 746
A Plan for Robustness 750
CHAPTER 22 Practical Considerations 756
Use and Abuse of the Computer 757
Price Shocks 764
Gambling Techniques—The Theory of Runs 769
Selective Trading 776
System Trade-Offs 778
Trading Limits and Disconnected Markets 784
Silver and Nasdaq—Too Good to Be True 787
Similarity of Systematic Trading Signals 789
CHAPTER 23 Risk Control 793
Mistaking Luck for Skill 794
Risk Aversion 795
Liquidity 799
Measuring Return and Risk 801
Leverage 808
Individual Trade Risk 811
Ranking of Markets for Selection 818
Probability of Success and Ruin 825
Compounding a Position 829
Equity Trends 833
Investing and Reinvesting: Optimal f 836
Comparing Expected and Actual Results 839
CHAPTER 24 Diversification and Portfolio Allocation 844
Diversification 845
Classic Portfolio Allocation Calculations 849
Portfolio Allocation Using Excel’s Solver 852
Kaufman’s Genetic Algorithm Solution
to Portfolio Allocation 855
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Contents
APPENDIX 1 Statistical Tables 869
Probability Distribution Tables 869
APPENDIX 2 Method of Least Squares 873
Operating Instructions 873
Computer Programs 874
Least-Squares Solution for Corn versus Soybeans 879
Least-Squares Solution for Soybeans Only 882
APPENDIX 3 Matrix Solution to Linear Equations
and Markov Chains 886
Direct Solution and Convergence Method 886
General Matrix Form 887
Direct Solution 888
Convergence Method 894
APPENDIX 4 Trigonometric Regression for Finding Cycles 896
Single-Frequency Trigonometric Regression 896
Two-Frequency Trigonometric Regression 900
APPENDIX 5 Fourier Transformation 904
Fast Fourier Transform Program 905
APPENDIX 6 Construction of a Pentagon 908
Construction of a Pentagon from One Fixed Diagonal 908
Construction of a Pentagon from One Side 909
Bibliography 910
Index
Preface
New Trading Systems and Methods, Fourth Edition
by Perry J. Kaufman
John Wiley & Sons © 2005
Preface
OVERVIEW
It's been only six years since the publication of the third edition but the market seems much different, and the experiences
of the investors and traders who have used the market have been intense. We've seen the end of an incredible bull
market in stocks that had everyone believing that 20% returns were to be expected; we've seen the Nasdaq index lose
over 80% of its value. We experienced 9/11, a date not to be forgotten, the invasion of both Afghanistan and Iraq, and
born-again terrorism. Everyday life has changed, and it is reflected in the markets.
Add to that the increasing advances in technology, communications that continue to make the world smaller, new trading
vehicles—such as index futures, exchange traded funds (ETFs), and sector indices—as well as a bombardment of
information through financial networks such as CNBC and Bloomberg. We also have seen a structural change in the way
prices move. What used to work may not work now. Individual stocks may now be following the index, instead of creating
it. Is it a new paradigm? Perhaps it is.
Preface
New Trading Systems and Methods, Fourth Edition
by Perry J. Kaufman
NOW WITH EQUITIES
Since its first publication, Trading Systems and Methods has focused its attention on futures markets. Most of the well-
known systems were created for these markets and migrated to equities. Over the years there has been a shift in this
trend so that both futures and stocks now share techniques. Credit must be given to the incredible bull market of the
1990s for attracting large numbers of systematic daytraders to the business.
In recognition of this shift, the fourth edition, New Trading Systems and Methods, has tried to balance examples of trading
methods using all markets, including stocks, ETFs, mutual funds, and futures. Some systems don't work as well for some
of these markets, and there are explanations why this might be so. You may find that a method is most robust when it can
be equally successful across different types of markets.
Creating a systematic method for trading equities can be very different from futures. The large number of stocks demands
that the same trading method be applied in the same way to any stock price series. Attempting to create a special set of
rules for each stock seems wrong and impractical. Therefore, a program that has a high chance of succeeding in trading
any stock is likely to be more robust than the traditional strategies applied to futures markets, each of which is unique. In
that regard, the equity strategist has a big advantage over the futures trader, whose method for trading copper or
soybeans is not likely to work on Eurodollars or the S&P 500.