Trading systems and methods (2013)

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3. Trading Systems and Methods ffirs.indd i ffirs.indd i 12/7/12 5:58 PM 12/7/12 5:58 PM

4. Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offi ces in North America, Europe, Australia and Asia, Wiley is glob- ally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifi cally for fi nance and invest- ment professionals as well as sophisticated individual investors and their fi nancial advi- sors. Book topics range from portfolio management to e-commerce, risk management, fi nancial engineering, valuation and fi nancial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.WileyFinance.com. ffirs.indd ii ffirs.indd ii 12/7/12 5:58 PM 12/7/12 5:58 PM

5. Trading Systems and Methods Fifth Edition PERRY J. KAUFMAN John Wiley & Sons, Inc. ffirs.indd iii ffirs.indd iii 12/7/12 5:58 PM 12/7/12 5:58 PM

6. Cover image: Nikada/iStockphoto Cover design: John Wiley & Sons, Inc. Copyright © 2005, 2013 by Perry J. Kaufman. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to 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 to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi cally disclaim any implied warranties of merchantability or fi tness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profi t 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 for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Charts created using TradeStation. ©TradeStation Technologies, Inc. 2001–2012. All rights reserved. No investment or trading advice, recommendation or opinions is being given or intended. Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. Library of Congress Cataloging-in-Publication Data: Kaufman, Perry J. Trading systems and methods / Perry J. Kaufman. — 5th ed. p. cm. Rev. ed. of: New trading systems and methods. 4th ed. c2005. Includes bibliographical references and index. ISBN 978-1-118-04356-1 (cloth) — 978-1-118-22224-9 (ebk) — 978-1-118-26092-0 (ebk) — 978-1-118-23603-1 (ebk) 1. Commodity exchanges—Statistical methods. 2. Technical analysis (Investment analysis) I. Kaufman, Perry J. New trading systems and methods. II. Title. HG6046.K34 2013 332.64′4–dc23 Printed in the United States of America. 2012030903 10 9 8 7 6 5 4 3 2 1 ffirs.indd iv ffirs.indd iv 12/7/12 5:58 PM 12/7/12 5:58 PM

7. To Barbara ffirs.indd v ffirs.indd v 12/7/12 5:58 PM 12/7/12 5:58 PM

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9. Contents Preface to the Fifth Edition xv CHAPTER 1 Introduction The Expanding Role of Technical Analysis Convergence of Trading Styles in Stocks and Futures A Line in the Sand between Fundamentals and Technical Analysis Professional and Amateur Random Walk Deciding on a Trading Style Measuring Noise Maturing Markets and Globalization Background Material Research Guidelines Objectives of This Book Profi le of a Trading System A Word about the Notation Used in This Book And Finally . . . 1 1 2 4 5 6 8 10 14 16 18 19 20 23 23 CHAPTER 2 Basic Concepts and Calculations About Data and Averaging On Average Price Distribution Moments of the Distribution: Variance, Skewness, and Kurtosis Standardizing Risk and Return The Index Standard Measurements of Performance Probability Supply and Demand 25 26 30 33 37 48 54 58 59 66 vii ftoc.indd vii ftoc.indd vii 12/7/12 5:58 PM 12/7/12 5:58 PM

10. viii CONTENTS CHAPTER 3 Charting Finding Consistent Patterns What Causes the Major Price Moves and Trends? The Bar Chart and Its Interpretation by Charles Dow Chart Formations Trendlines One-Day Patterns Continuation Patterns Basic Concepts in Chart Trading Accumulation and Distribution—Bottoms and Tops Episodic Patterns Price Objectives for Bar Charting Implied Strategies in Candlestick Charts Practical Use of the Bar Chart Evolution in Price Patterns 79 80 82 83 92 94 102 113 117 118 132 133 139 144 148 CHAPTER 4 Charting Systems and Techniques Dunnigan and the Thrust Method Nofri’s Congestion-Phase System Outside Days with an Outside Close Inside Days Pivot Points Action and Reaction Channel Breakout Moving Channels Commodity Channel Index Wyckoff ’s Combined Techniques Complex Patterns A Study of Charting Patterns Bulkowski’s Chart Pattern Rankings 151 152 155 157 158 158 159 167 170 171 172 173 176 178 CHAPTER 5 Event-Driven Trends Swing Trading Constructing a Swing Chart Using a Swing Filter Point-and-Figure Charting The N-Day Breakout 181 182 184 195 222 CHAPTER 6 Regression Analysis Components of a Time Series Characteristics of the Price Data 235 235 236 ftoc.indd viii ftoc.indd viii 12/7/12 5:58 PM 12/7/12 5:58 PM

11. ix Contents Linear Regression Linear Correlation Nonlinear Approximations for Two Variables Transforming Nonlinear to Linear Evaluation of Two-Variable Techniques Multivariate Approximations ARIMA Basic Trading Signals Using a Linear Regression Model Measuring Market Strength 238 248 252 256 257 259 267 273 276 CHAPTER 7 Time-Based Trend Calculations Forecasting and Following Price Change over Time The Moving Average Geometric Moving Average Accumulative Average Reset Accumulative Average Drop-Off Eff ect Exponential Smoothing Plotting Lags and Leads 279 279 284 284 292 293 293 293 293 307 CHAPTER 8 Trend Systems Why Trend Systems Work Basic Buy and Sell Signals Bands and Channels Applications of a Single Trend Comparison of Major Trend Systems Techniques Using Two Trendlines Multiple Trends and Common Sense Comprehensive Studies Selecting the Right Trend Method and Speed Moving Average Sequences: Signal Progression Early Exits from a Trend Moving Average Projected Crossovers 309 309 314 320 330 336 350 356 359 359 363 366 366 CHAPTER 9 Momentum and Oscillators Momentum Divergence Index Oscillators 369 370 384 385 ftoc.indd ix ftoc.indd ix 12/7/12 5:58 PM 12/7/12 5:58 PM

12. x CONTENTS Double-Smoothed Momentum Velocity and Acceleration Hybrid Momentum Techniques Momentum Divergence Some Final Comments on Momentum 404 412 416 418 426 CHAPTER 10 Seasonality and Calendar Patterns A Consistent Factor The Seasonal Pattern Popular Methods for Calculating Seasonality Seasonal Filters Seasonality and the Stock Market Common Sense and Seasonality 427 428 429 430 456 478 483 CHAPTER 11 Cycle Analysis Cycle Basics Uncovering the Cycle Maximum Entropy Cycle Channel Index Short Cycle Indicator Phasing 485 485 494 514 520 521 523 CHAPTER 12 Volume, Open Interest, and Breadth A Special Case for Futures Volume Variations from the Normal Patterns Standard Interpretation Volume Indicators Breadth Indicators Interpreting Volume and Breadth Systematically An Integrated Probability Model Intraday Volume Patterns Filtering Low Volume Market Facilitation Index 527 527 529 531 535 546 554 558 559 562 564 CHAPTER 13 Spreads and Arbitrage Dynamics of Futures Intramarket Spreads Carrying Charges Spreads in Stocks Spread and Arbitrage Relationships Risk Reduction in Spreads 565 566 567 569 570 571 ftoc.indd x ftoc.indd x 12/7/12 5:58 PM 12/7/12 5:58 PM

13. xi Contents Arbitrage The Carry Trade Changing Spread Relationships Intermarket Spreads 572 596 600 602 CHAPTER 14 Behavioral Techniques Measuring the News Event Trading Commitment of Traders Report Opinion and Contrary Opinion Fibonacci and Human Behavior Elliott’s Wave Principle Price Target Constructions Using the Fibonacci Ratio Fischer’s Golden Section Compass System W. D. Gann—Time and Space Financial Astrology 617 618 623 635 641 648 651 660 662 666 671 CHAPTER 15 Pattern Recognition Projecting Daily Highs and Lows Time of Day Opening Gaps Weekday, Weekend, and Reversal Patterns Computer-Based Pattern Recognition Artifi cial Intelligence Methods 685 687 689 699 711 732 735 CHAPTER 16 Day Trading 737 738 744 753 759 774 775 Impact of Transaction Costs Key Elements of Day Trading Trading Using Price Patterns Intraday Breakout Systems Intraday Volume Patterns Intraday Price Shocks CHAPTER 17 Adaptive Techniques Adaptive Trend Calculations Adaptive Variations Other Adaptive Momentum Calculations Adaptive Intraday Breakout System An Adaptive Process Considering Adaptive Methods 779 779 788 793 796 797 798 ftoc.indd xi ftoc.indd xi 12/7/12 5:58 PM 12/7/12 5:58 PM

14. xii CONTENTS CHAPTER 18 Price Distribution Systems Measuring Distribution Use of Price Distributions and Patterns to Anticipate Moves Distribution of Prices Steidlmayer’s Market Profi le Using Daily Distributions to Identify Support and Resistance 801 801 805 811 822 830 CHAPTER 19 Multiple Time Frames Tuning Two Time Frames to Work Together Elder’s Triple-Screen Trading System Robert Krausz’s Multiple Time Frames Martin Pring’sKST System 833 833 835 838 842 CHAPTER 20 Advanced Techniques Measuring Volatility Using Volatility for Trading Trade Selection Using Volatility Liquidity Trends and Price Noise Trends and Interest Rate Carry Expert Systems Fuzzy Logic Fractals, Chaos, and Entropy Neural Networks Genetic Algorithms Replication of Hedge Funds 845 845 856 861 867 868 871 871 875 880 886 895 902 CHAPTER 21 System Testing Expectations Identifying the Parameters Selecting the Test Data Testing Integrity Searching for the Best Result Visualizing and Interpreting Test Results Large-Scale Testing Refi ning the Strategy Rules Arriving at Valid Test Results Comparing the Results of Two Systems Profi ting from the Worst Results 905 907 908 910 916 919 922 932 937 938 946 950 ftoc.indd xii ftoc.indd xii 12/7/12 5:58 PM 12/7/12 5:58 PM

15. xiii Contents Retesting for Changing Parameters Testing across a Wide Range of Markets Price Shocks Anatomy of an Optimization Summarizing Robustness 951 954 970 972 976 CHAPTER 22 Practical Considerations Use and Abuse of the Computer Extreme Events Gambling Techniques—The Theory of Runs Selective Trading System Trade-Off s Trading Limits and Disconnected Markets Silver and NASDAQ—Too Good to Be True Similarity of Systematic Trading Signals 983 984 992 1000 1011 1012 1018 1020 1021 CHAPTER 23 Risk Control 1027 1027 1028 1033 1034 1046 1049 1050 1059 1062 1072 1076 1080 1085 1088 1092 Mistaking Luck for Skill Risk Aversion Liquidity Measuring Return and Risk Leverage Leverage Based on Exposure Individual Trade Risk Kaufman on Stops and Profi t-Taking Ranking of Markets for Selection Probability of Success and Ruin Entering a Position Compounding a Position Equity Trends Investing and Reinvesting: Optimal f Comparing Expected and Actual Results CHAPTER 24 Diversifi cation and Portfolio Allocation Diversifi cation Changing Correlations Types of Portfolio Models Classic Portfolio Allocation Calculations Finding Optimal Portfolio Allocation Using Excel’s Solver Kaufman’s Genetic Algorithm Solution to Portfolio Allocation (GASP) Volatility Stabilization 1099 1100 1105 1105 1107 1109 1114 1142 ftoc.indd xiii ftoc.indd xiii 12/7/12 5:58 PM 12/7/12 5:58 PM

16. xiv CONTENTS APPENDIX 1 Statistical Tables 1147 APPENDIX 2 Matrix Solution to Linear Equations and Markov Chains 1151 APPENDIX 3 Trigonometric Regression for Finding Cycles 1161 Bibliography 1175 About the Companion Website 1191 Index 1193 ftoc.indd xiv ftoc.indd xiv 12/7/12 5:58 PM 12/7/12 5:58 PM

17. Preface to the Fifth Edition I collapse in 2007 proved us wrong. We learned what risk was all about, when money was pulled from every possible investment at the same time. In many cases, the investments that were liquidated had no other relationship than having profi ts that were needed to cover losses elsewhere. The principles of diversifi cation held true, but we saw the worst- case scenario, where everything moved in the same way at the same time. It was an event with a very low probability, but not zero. During the years that have followed, we would expect much more focus on risk man- agement, rather than risk measurement. Understanding how to reduce risk before the fact is much more productive than identifying it afterward. Some hedge funds, following in the steps of Long-Term Capital Management, have chosen to see this as a rare event, not likely to be repeated. The rationale for this is that, in order to reduce the chances of large risk, you must also reduce returns. They see investors as preferring the small chance of a large loss to the less acceptable assurance of lower profi ts. I won’t try to judge the merits of this decision. On the other hand, we should all understand the best choices for controlling risk. With that in mind, many of the changes in this edition address risk control, from the indi- vidual trade level, to the strategy rules, to the portfolio. n the past eight years, since the last edition, our industry has continued to change. The extraordinary bull market of the late 1990s, followed by the bursting of the tech bub- ble in 2000 seemed to be events that could never be overshadowed, but the subprime COHERENCE One of the improvements in this edition is the added coherence from one section to another and from one chapter to another. There will be references, both forward and backward, showing similarities between many techniques. By incorporating those refer- ences, some of the duplication has been removed. Considerable effort was made to use the same notation throughout the book, in hope that it will make the formulas easier to understand. You will also fi nd that there is a greater attempt to make this material fl ow from section to section as a continuous learning process. xv flast.indd xv flast.indd xv 12/7/12 5:58 PM 12/7/12 5:58 PM

18. xvi PREFACE TO THE FIFTH EDITION MORE STRATEGIES, MORE PROGRAMS AND SPREADSHEETS Each year brings new ideas, and many articles and books have shed light on new tech- niques or better ways to approach an old problem. Wherever possible, those ideas have been added here, with references to the original material. There is more cross-pollination with the securities industry, and you will fi nd more terms now used by both futures and stock traders. Examples make learning easier, and this edition has many more examples, along with more programs and spreadsheets that will help you take whichever ideas are appealing and try them on your own. Wherever possible, the spreadsheet code uses “offset” to allow the calculation periods to be changed. These examples continue to use TradeStation and Excel, which remain the most popular tools. While there are many other choices, code from these two sources can be easily converted to other programs. UPDATED CHARTS Along with more examples, many of the old examples and charts have been brought up to date. While there may be an historic interest in market patterns during the 1970s and 1980s, the recent 10 years provide dramatic price movements and seem more relevant. We would all agree that it’s good for a strategy to have been profi table in the 1980s, but more important that it succeeded during the past 5 or 10 years. In many cases, the old patterns are still unique and should not be ignored, but every book has its limits. SEARCHING FOR ROBUSTNESS The goal of a system developer and/or a trader is to fi nd or create a trading method that will work in many different situations, hopefully across many different markets, and keep working for as long as possible. A solution that is robust satisfi es those objec- tives. Because if its importance, there are comments throughout the book addressing the robustness of various methods and ways to enhance that quality. Chapter 21, System Testing, addresses this directly, but it is not the only place. Robustness is an easy concept to understand, but a robust strategy has a return and risk profi le that is not as attractive as one that has been fi tted to the data. Success with fewer rules over more markets and data yields robustness, but at the price of lower returns and higher risk. It is necessary to understand and embrace the natural risk of a strategy and market in order to succeed in the long term. If you try to engi- neer all of the risk out of a trade, it will only surface somewhere else when it is least welcome. flast.indd xvi flast.indd xvi 12/7/12 5:58 PM 12/7/12 5:58 PM

19. xvii Preface to the Fifth Edition COMPANION WEBSITE The companion website has been greatly expanded with both TradeStation programs (Version 9) and Excel 2010 spreadsheets. It is expected that MetaStock code will be added in the near future. There is also a list of contents at the back of this book. When- ever a website program relates to a section of the book, there is an icon in the margin to remind you of its availability. Hopefully, this will make the development and verifi cation of new ideas more convenient. WITH APPRECIATION This book draws on the hard work and creativity of hundreds of traders, fi nancial special- ists, engineers, and many others who are passionate about the markets. They continue to redefi ne the state-of-the-art and provide all of us with both profi table techniques and valuable tools. A long overdue thanks to Janette Perez of TradeStation for her generous help. My gratitude to Pamela van Giessen and Emilie Herman of John Wiley & Sons, who continue to provide immeasurable help and encouragement. And to my wife, Barbara, whose everlasting support is only enhanced by rolling her eyes whenever I say that this is my last book, ever. As a fi nal note, I would like to thank all the previous readers who sent messages about typographical errors, omissions, and just simple errors. They have all been corrected. It makes this edition that much better. PERRY J. KAUFMAN Freeport, Grand Bahama November 2012 flast.indd xvii flast.indd xvii 12/7/12 5:58 PM 12/7/12 5:58 PM

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