The new edition of the definitive reference to trading systems - expanded and thoroughly updated.
Professional and individual traders haverelied on Trading Systems and Methods for over three decades. Acclaimed trading systems expert Perry Kaufman provides complete, authoritative information on proven indicators, programs, systems, and algorithms. Now in its sixth edition, this respected book continues to provide readers with the knowledge required to develop or select the trading programs best suited for their needs. In-depth discussions of basic mathematical and statistical concepts instruct readers on how much data to use, how to create an index, how to determine probabilities, and how best to test your ideas. These technical tools and indicators help readers identify trends, momentum, and patterns, while an analytical framework enables comparisons of systematic methods and techniques.
This updated, fully-revised edition offers new examples using stocks, ETFs and futures, and provides expanded coverage of arbitrage, high frequency trading, and sophisticated risk management models. More programs and strategies have been added, such as Artificial Intelligence techniques and Game Theory approaches to trading. Offering a complete array of practical, user-ready tools, this invaluable resource:
- Offers comprehensive revisions and additional mathematical and statistical tools, trading systems, and examples of current market situations
- Explains basic mathematical and statistical concepts with accompanying code
- Includes new Excel spreadsheets with genetic algorithms, TradeStation code, MetaStock code, and more
- Provides access to a companion website packed with supplemental materials
Trading Systems and Methods is an indispensable reference on trading systems, as well as system design and methods for professional and individual active traders, money managers, trading systems developers.
Table of Contents
Preface xv
Chapter 1 Introduction 1
The Expanding Role of Technical Analysis 1
Convergence of Trading Styles in Stocks and Futures 3
Professional and Amateur 5
Random Walk 6
Deciding on a Trading Style 7
Measuring Noise 9
Maturing Markets and Globalization 12
Background Material 14
System Development Guidelines 15
Objectives of This Book 16
Profile of a Trading System 17
A Word about the Notation Used in This Book 20
A Final Comment 20
Chapter 2 Basic Concepts and Calculations 21
A Brief Word About Data 22
Simple Measures of Error 23
On Average 24
Price Distribution 28
Moments of the Distribution: Mean, Variance, Skewness, and Kurtosis 32
Choosing Between Frequency Distribution and Standard Deviation 37
Measuring Similarity 38
Standardizing Risk and Return 40
The Index 45
An Overview of Probability 50
Supply and Demand 56
Chapter 3 Charting 67
Finding Consistent Patterns 68
What Causes the Major Price Moves and Trends? 70
The Bar Chart and Its Interpretation by Charles Dow 71
Chart Formations 80
Trendlines 81
One-Day Patterns 89
Continuation Patterns 101
Basic Concepts in Chart Trading 105
Accumulation and Distribution: Bottoms and Tops 106
Episodic Patterns 118
Price Objectives for Bar Charting 119
Implied Strategies in Candlestick Charts 126
Practical Use of the Bar Chart 131
Evolution in Price Patterns 134
Chapter 4 Charting Systems 137
Dunnigan and the Thrust Method 138
Nofri’s Congestion-Phase System 141
Outside Days and Inside Days 143
Pivot Points 145
Action and Reaction 146
Programming the Channel Breakout 153
Moving Channels 155
Commodity Channel Index 156
Wyckoff’s Combined Techniques 157
Complex Patterns 158
Computer Recognition of Chart Patterns 160
Chapter 5 Event-Driven Trends 167
Swing Trading 167
Point-and-Figure Charting 176
The N-Day Breakout 195
Chapter 6 Regression Analysis 207
Components of a Time Series 207
Characteristics of the Price Data 208
Linear Regression 210
Linear Correlation 218
Nonlinear Approximations for Two Variables 222
Transforming Nonlinear to Linear 225
Multivariate Approximations 228
ARIMA 233
Basic Trading Signals Using a Linear Regression Model 238
Measuring Market Strength 241
Chapter 7 Time-Based Trend Calculations 243
Forecasting and Following 244
Price Change over Time 247
The Moving Average 248
The Moving Median 255
Geometric Moving Average 255
Accumulative Average 256
Drop-off Effect 256
Exponential Smoothing 257
Plotting Lags and Leads 267
Chapter 8 Trend Systems 269
Why Trend Systems Work 269
Basic Buy and Sell Signals 274
Bands and Channels 280
Choosing the Calculation Period for the Trend 290
A Few Classic Single-Trend Systems 291
Comparison of Single-Trend Systems 295
Techniques Using Two Trendlines 307
Three Trends 314
Comprehensive Studies 318
Selecting the Trend Speed to Fit the Problem 318
Moving Average Sequences: Signal Progression 319
Early Exits from a Trend 322
Projecting Moving Average Crossovers 323
Early Identification of a Trend Change 323
Chapter 9 Momentum and Oscillators 325
Momentum 326
Adding Volume to Momentum 339
Divergence Index 342
Visualizing Momentum 343
Oscillators 345
Double-Smoothed Momentum 364
Velocity and Acceleration 369
Hybrid Momentum Techniques 375
Momentum Divergence 377
Some Final Comments on Momentum 385
Chapter 10 Seasonality and Calendar Patterns 387
Seasonality Never Disappears 388
The Seasonal Pattern 389
Popular Methods for Calculating Seasonality 390
Classic Methods for Finding Seasonality 408
Weather Sensitivity 420
Identifying Seasonal Trades 422
Seasonality and the Stock Market 439
Common Sense and Seasonality 449
Chapter 11 Cycle Analysis 451
Cycle Basics 451
Uncovering the Cycle 465
Maximum Entropy 481
Short Cycle Indicator 489
Phasing 491
Chapter 12 Volume, Open Interest, and Breadth 495
Futures Volume and Open Interest 496
Extended Hours and 24-Hour Trading 497
Variations from the Normal Patterns 498
Standard Interpretation 502
Volume Indicators 506
Breadth Indicators 518
Is One Volume or Breadth Indicator Better than Another? 524
More Trading Methods Using Volume and Breadth 525
An Integrated Probability Model 533
Intraday Volume Patterns 534
Filtering Low Volume 537
Market Facilitation Index 538
Chapter 13 Spreads and Arbitrage 541
Dynamics of Futures Intramarket Spreads 542
Carrying Charges 543
Spreads in Stocks 546
Spread and Arbitrage Relationships 547
Risk Reduction in Spreads 548
Arbitrage 549
The Carry Trade 580
Implied Versus Historic Volatility 584
Changing Spread Relationships 589
Intermarket Spreads 591
Chapter 14 Behavioral Techniques 607
Measuring the News 608
Event Trading 614
Commitment of Traders Report 627
Opinion and Contrary Opinion 635
Fibonacci and Human Behavior 642
Elliott’s Wave Principle 646
Price Target Constructions Using the Fibonacci Ratio 656
Fischer’s Golden Section Compass System 657
W. D. Gann: Time and Space 662
Financial Astrology 668
Chapter 15 Short-Term Patterns 683
Projecting Daily Highs and Lows 684
Time of Day 686
Opening Gaps 699
Weekday, Weekend, and Reversal Patterns 707
Computer-Based Pattern Recognition 729
Artificial Intelligence Methods 732
Chapter 16 Day Trading 735
Impact of Transaction Costs 736
Slippage and Liquidity 738
Key Elements of Day Trading 741
Trading Using Price Patterns 748
Intraday Breakout Systems 752
High-Frequency Trading 769
Intraday Volume Patterns 773
Intraday Price Shocks 773
Chapter 17 Adaptive Techniques 777
Adaptive Trend Calculations 777
Adaptive Variations 787
Other Adaptive Momentum Calculations 792
Adaptive Intraday Breakout System 795
An Adaptive Process 797
Chapter 18 Price Distribution Systems 799
Accuracy is in the Data 799
Use of Price Distributions and Patterns to Anticipate Moves 803
The Importance of the Shape of the Distribution 808
A Purchaser’s Inventory Model 819
A Producer’s Selling Model 823
Steidlmayer’s Market Profile 824
A Fast Version of Market Profile 833
Chapter 19 Multiple Time Frames 835
Tuning Two Time Frames to Work Together 836
Displaying Two or Three Time Frames 837
Elder’s Triple Screen Trading System 838
Robert Krausz’s Multiple Time Frames 841
Martin Pring’s KST System 845
Chapter 20 Advanced Techniques 849
Measuring Volatility 849
The Price-Volatility Relationship 856
Using Volatility for Trading 860
Liquidity 869
Trends and Price Noise 871
Trends and Interest Rate Carry 874
Fuzzy Logic 874
Expert Systems 880
Game Theory 885
Fractals, Chaos, and Entropy 890
Genetic Algorithms 897
Neural Networks 905
Machine Learning and Artificial Intelligence 915
Replication of Hedge Funds 917
Chapter 21 System Testing 919
Expectations 920
Selecting the Test Data 921
Testing Integrity 927
Identifying the Parameters 929
Searching for the Best Result 931
Too Large to Test Everything 935
Visualizing and Interpreting Test Results 937
The Impact of Costs 950
Refining the Strategy Rules 951
Arriving at Valid Test Results 952
Comparing the Results of Two Trend Systems 959
Retesting to Stay Current 962
Profiting from the Worst Results 963
Testing Across a Wide Range of Markets 965
Price Shocks 970
Anatomy of an Optimization 972
Summarizing Robustness 976
Chapter 22 Adding Reality 983
Some Computer Basics 983
The Abuse of Power 988
Final Steps before Launch 989
Extreme Events 992
Gambling Techniques: The Theory of Runs 1000
Selective Trading 1008
System Trade-Offs 1008
Silver and Amazon: Too Good to Be True 1013
Similarity of Systematic Trading Signals 1014
Chapter 23 Risk Control 1021
Mistaking Luck for Skill 1021
Risk Aversion 1022
Liquidity 1027
Measuring Return and Risk 1028
Position Sizing 1041
Individual Trade Risk 1046
Kaufman on Stops and Profit-Taking 1050
Entering a Position 1053
Leverage 1058
Compounding a Position 1060
Selecting the Best Markets 1064
Probability of Success and Ruin 1072
Managing Equity Risk 1075
Ideal Leverage Using Optimal f 1078
Comparing Expected and Actual Results 1081
Chapter 24 Diversification and Portfolio Allocation 1089
Diversification 1090
Types of Portfolio Models 1095
Classic Portfolio Allocation Calculations 1097
Finding Optimal Portfolio Allocation Using Excel’s Solver 1100
Kaufman’s Genetic Algorithm Solution to Portfolio Allocation (GASP) 1103
Volatility Stabilization 1129
About the Companion Website 1134
Index 1135
