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

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

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

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 sys­tems for the futures and equities markets. The book begins by develop­ing 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 be­tween 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.