.The ROC indicator displays upward price momentum that can becombined with an SMA to establish basic trading rules. An example of along-only system (no short positions) is one that establishes a positionwhen the ROC crosses up above the SMA and exits the position when itcrosses down below the SMA. Since the system creates a directional position and is not market neutral, trending periods are optimal. It thereforemakes sense to add an ADX rule to improve our chances of entering positions during a trending phase.The process was initiated by testing one set of rules using the simplemomentum set-up described, then varying the speed and adding filters. Thetesting was performed on the 100 stocks of the S&P 100 Index ($OEX). Ittested the period from 1980 to 1998 in two system runs, 1980–1989 and1990–1998. So the test includes 100 stocks from a specific index and nineteen years of data. Importantly, the actual number of stocks evaluated inthe earliest phases of the backtest was limited. For example, Cisco, Microsoft, and Dell are part of the system list but were not members of theS&P 100 in 1980. In fact, they weren’t even public companies. As a result,no trades could be triggered for these stocks, and significantly fewer than100 companies were part of the system backtests from 1980 through 1989.Table 9.3 lists the specific rules for the long-only ROC-ADX system. Thesystem will produce a buy trigger and open a long position, then close thetrade when the sell alert is triggered. A profit or loss results, with the profittrade exit rule the same as the loss trade exit rule. The buy entry occurs
TABLE 9.3 Base ROC-ADX SystemSummary of Example System
MomentumSystem ElementsTrade Entry
Trade Exit
Long Only20-day ROC and 5-day SMA with ADX.Buy when 20-day ROC crosses up abovethe 5-day SMA on the ROC.ADX must be above 18.Sell when 20-day ROC crosses downbelow the 5-day SMA on the ROC.No ADX requirement.
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when the 20-day ROC indicator crosses above the five-day ROC simple moving average and there is an indicator reading above 18 for the ADX. The position is closed when the ROC drops below the five-day SMA. And that’s it!The first system run included data from January 1, 1980, through December 31, 1989. A variety of ROC-ADX combinations were ultimately tested using this period, with top performers included in future test periods. The testsassumed a starting account size of $50,000 for each system, with a trade sizethat represented 10 percent of the account. That means each trade varied indollar size, but represented a similar portion of the remaining cash. The brokerage cost (i.e., commissions and fees) was $10 per trade. A roundtrip trade(i.e., buy to open and sell to close) included $20 in commissions.Account sizeTrade sizeBrokerageSecurity
$50,00010%$10, one-wayS&P 100 stocks (2005)
The chart shown in Figure 9.6 provides a view of trade entry and exitwhen the ROC was set to 13 and the MA set to 20 (one of the top two systems). The ADX was greater than 18 at trade entry and declining at tradeexit. The chart is a daily OHLC for Amgen, Inc. (AMGN).After running the initial test, there was good news and bad newsabout the trading system. The system had a small net loss—that’s the badnews. From Table 9.4, we can see that the system generated 112 trades at
FIGURE 9.6 ROC-ADX System Trade for AMGN (Source: www.ProﬁtSource.com)
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TABLE 9.4 Initial ROC-ADX System ResultsSystemNetProﬁt
Total #of Trades
AverageP/L %
Maximum AverageDD%*DD%*
StandardTotal Costs Deviation
($1,564.01)
112
–3.13%
–15.63%
2240
–3.59%
7.06%
*DD% = Drawdown percentage.
an average loss of 3.1 percent. The total cost for the trades was $2,240, or112  $20 per roundtrip. The biggest drawdown, or decline in accountvalue, was 15.6 percent.However, the results were consistent—which is good news for anytrading system. Once a trader finds a profitable system, consistency (via thestandard deviation of returns) is an important measurement to evaluate.Once a system is developed, it can be refined and the results can beimproved. Doing so can sometimes turn a losing system into a winner. Inthis example, the system failed to produce profits because it generated alot more losing trades than winning ones. Table 9.5 displays the resultsbreakdown by winning trades and losing trades. The losing trades outnumbered the winners more than two to one. However, the percentage ofgain from the winners was more than double the percentage of loss fromthe losers. Therefore, the strategist might consider looking for ways to diminish the number of losses by taking steps to reduce the total number oftrades or by exiting losing trades sooner.Changing the length of the moving average or the speed of either theADX or the ROC indicators can also modify the system. Sometimes verysubtle changes can make a very significant difference, especially when thebacktest encompasses a long time frame or a large number of investments. So if the parameters for the test seem logical, don’t give up afterthe first attempt at building a trading system. If at first you don’t succeed,try and try again.After a series of tests (36 initial combinations), the cumulative results(1980–1998) for the two best systems include those shown in Table 9.6.When performing backtesting for a system, it is important to includelong periods of time in order to capture various market phases (bullish,
TABLE 9.5 ROC-ADX System Results by Winners and LosersGrossProﬁt or Loss
# ofTrades
% P (L)Trades
AverageP or L %
ConsecutiveP or L Trades
$12,237.13($13,801.14)
3280
28.6%71.4%
7.84%–3.43%
310
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TABLE 9.6 ROC-ADX System Results for Top PerformersSystem#
Total Proﬁt,Loss, and# ofReturnTrades
% ProﬁtableTrades
P:L
AverageP/L %
StandardDeviation
1
$111,511223%
1,092
46.8%
2.5
5.63%
31.8%
6
$103,991208%
1,799
40.0%
2.8
2.78%
41.3%
bearish, and sideways). A system should be effective for a variety of markets and under a variety of market conditions. In addition, profitability ofthe system should be examined as well as the stability of the system. Theparameters of the two top-performing systems in Table 9.6 are given inTable 9.7.
Stop PlacementsStops were added to the system based on the maximum adverse excursion percent (MAE%) from previous results. The MAE% is a drawdowntype calculation—it is the maximum drop in price below the entry price,in percentage terms. By calculating a stop based on the MAE%, the systemdictates stop placement, versus an arbitrary risk value assigned by thetrader. Managing risk is not arbitrary, but the system doesn’t care whatthis level is. It is better to allow it to work as it should, and then determinewhether the system risk is acceptable. (Certainly more tests could be runthat incorporate small stop percentages.)
TABLE 9.7 ROC-ADX Top Performers System DetailsEntryand Exit
Entry
Entry
Exit
#
ROC,ROC-MA
ADX
ADXIncreasing
ADXDecreasing
Stop
1
13, 20
> 18
Yes, for 3days
Yes, for 5days
15%
No
Yes, for 5days
15%
6
8, 20
> 18
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OptimizationWhen a trader wants to optimize results—that is, to determine the best indicator speed from both a profitability and stability standpoint—a methodical approach must be taken. Although a few speeds were selectedand tested for this exercise, a truly optimized system is one that is createdby running through a sequence of values (i.e., 1 to 50 by stepping up oneincrement; or 2 to 50 stepped up by two increments).
RobustnessSystem robustness refers to a few different things, among them the ability of the system to work in a variety of markets under a variety of conditions. The trader also wants to consider whether the system is logical andwhether the testing was performed properly. The logic test fails for theROC-ADX system because the exit signals are required together; the ROCneeds to cross below the ROC-MA and the ADX needs to be declining.A declining ADX indicates a trendless period. Since trending conditions are optimal for this system, it is beneficial to exit a position whenthe ADX is declining. When we require five days of declining ADX values,meeting both criteria—(1) ROC crossing below the ROC-MA, and (2) afive-day declining ADX—may be difficult. Exit signals using either thefirst or the second criterion may be superior to one that requires both.A second signal difficulty includes the requirement for five days of declining ADX; perhaps an ADX lower than the reading from five days ago isbetter. We tested ourselves and were surprised to find that there appearedto be a couple of settings at this point that are both profitable and stable,with manageable drawdowns. How this system is profitable (given theexit flaws) needs to be better understood before using it.
SYSTEM TESTING DESIGN SUMMARIZEDSystem traders have a variety of systems available to them in the sameway option traders have a variety of strategies available. A long-only system will benefit from bullish periods, while one that also establishes shortpositions will generally be better as market conditions vary. At the sametime, the system should fit each individual’s trading style and account size.Such considerations include the number of trades generated over a periodof time and whether the system is applied to volatile, fast-moving marketsor to slow ones. Importantly, once the system is developed, that is not theend. The markets are always changing. So a system should also continually be evaluated and tweaked in order to stay current with market conditions. An example of a basic system design is shown in Table 9.8.
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TABLE 9.8 System Design ExampleIdentify/Run
Example
1.
Strategy
Momentum via rate of change (ROC)
2.
Trading entry rules/signals
ROC crossing above ROC-MA
3.
Trading exit rules/signals
ROC crossing below ROC-MA
4.
Optimal conditions
Trending
5.
Condition ﬁlter
ADX rising (entry), declining (exit)
6.
Test approach
Three speeds for ROC, three speeds for ROC-MA
7.
Identify data period
1980–1989 and 1989–1998
8.
Market tested
OEX stocks, 2005 components
9.
Initial test and review
1980–1989 period: 36 combinations
10.
Second test and review
1989–1998 period: 8 combinations
11.
Risk management
Add system-dictated stops
12.
Third test and review
Five combinations for 1980–1998
13.
Final test and review
Two combinations
ENHANCE SYSTEM PERFORMANCE WITH OPTIONETICSThe Optionetics (www.optionetics.com) philosophy of trading is valuablenot only to novice system traders; long-time professional system traderscan benefit as well. Overlaying the Optionetics way of trading with anytrading system that trades liquid markets can significantly enhance thatsystem’s performance. The Optionetics methodology facilitates the implementation of a system’s money management rules by using option-tradingtechniques certainly worthy of application.To validate this assertion, we’ll review the Optionetics philosophy,trading system basics, and money management approaches. We then conclude with the beneficial impacts the Optionetics philosophy can have ona trader’s current trading system.So just what does the Optionetics philosophy encompass? The absolute crux of this approach can be classified as a scientific method ofanalysis that utilizes options as tools to minimize risk exposure. Sincerisk is directly correlated to a trader’s number one nemesis—stress/emotion—it stands to reason that if you can get a good handle on risk, yourability to execute your trading plan flawlessly will improve dramatically.The Optionetics approach to the markets predefines the risk and reward of each and every trade to determine its feasibility. Once the risk/reward ratio has been revealed and the maximum loss position is clearlydefined, a natural calm comes over the trader with a very pronounced
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stress-level reduction. The result is much better decision making duringthe trade execution and management phase.Another major benefit of trading using the Optionetics approach isthat it surrounds your core trading or belief system with a flexible investment plan. This flexibility allows the traders to employ a variety of optionstrategies that best exploit the current market environment. For long-termsurvival in the trading business, the ability to change directions is absolutely essential. This attribute, which is at the heart of the Optioneticsphilosophy, turns the naturally dynamic trading environment of the markets to extremely profitable opportunities.Now let’s take a look at what constitutes a typical trading system. Asmentioned earlier, there are three building blocks in any system: marketentry, exit with a profit, and exit with a loss. Identifying these and makingdecisions about them is a key element in crafting a successful trading system. Before you trade, the system should tell you:1. Where should I get into the market?2. Where should I get out with a profit?3. Where should I get out with a loss?
You need to know the answer to all three of these questions beforeyou trade. If you know the answer to only one or two, you do not have acomplete trading system.Of course, with all sound trading system approaches, the trader musthave some complementary money management rules that can be effectively applied. Money management takes the trader past the point of no return. For example, a trader who makes $100,000 over two years and thenloses the $100,000 during the following two years has a return of zero dollars. This is why money management is such a key factor.Now let’s examine how the Optionetics approach can enhance the implementation of both the trading system being employed and the accompanying money management rules that are being applied. The use of putsand calls to hedge against long and short stock or index positions offerthe following benefits:• Greater protection than stop-losses.• Protection of stock or index positions from major losses.• Elimination of the risk of receiving a margin call.• Little maintenance required, allowing you to lock in profits.Given the fact that stop-losses are essential components of a goodmoney management system, the Optionetics approach provides a far
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superior method of protection by the utilization of options. For example, with the distinct possibility of a major gap down or up, the traditional stop-loss can encounter major slippage. Employing an option asyour risk reduction strategy eliminates this negative slippage impact.Also, by clearly delineating the risk and reward picture of every trade,the Optionetics discipline automatically enforces the most importantmoney management rule of all: When a trading system generates marketentry, market exit with loss, or market exit with profit price levels, the Optionetics methodology can really go to work. The approach allows you toapply the optimum options strategy based on the system’s forecastedprice levels as well as the underlying option’s current and forecastedvolatility.Furthermore, the trader can be as flexible as needed, allowing adjustments to be based on market flow, keeping the position intact by lockingin profits, continuing to minimize risk, and providing the staying power tosee the trade to fruition versus being continually whipsawed in and out ofthe market. With so many benefits of applying the Optionetics trading philosophy, it really behooves the trader to master these trading principlesand use them faithfully in conjunction with your current trading system.The improvement in your system’s profitability, along with better risk-toreward profiles, makes it an approach that is truly worth implementing.
CONCLUSIONTrading systems facilitate trader discipline, pure and simple. They givethe trader a way to interpret, quantify, and classify market behavior in anunbiased manner. They also define potential opportunities by providingspecific trading signals. Following these signals can facilitate the development of trading skills as well as the discipline required to empower thetrader to execute his or her trading plan. The advantage to systems trading is that it tries to take some of the emotion out of the market. Identifying the three building blocks—market entry, exit with a profit, and exitwith a loss—is a key element to developing a successful trading system.A trading system design involves the following nine important steps:1. Know which markets you feel comfortable with and can afford to trade.2. Learn all you can about these markets so you will know which indica-
tors to use.3. Design a trading system around your knowledge.4. Test your system for flaws before you trade real-time.
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5. Decide when to get into the market.6. Decide when to get out with a profit.7. Decide when to get out with a loss.8. Implement your trading system.9. Fine-tune your trading system and continually evaluate your system.
We also took a look at a couple of systems—the Volex system and theDogs of the Dow—and how each generates trading signals. The Volex system essentially uses changes in volatility to forecast a change in price andallows the trader to confirm trends or changes in direction. It is particularly effective for very liquid markets such as the major indexes. Tom Gentile’s point and figure Volex system for trading the S&P 500 Index was alsopresented along with its impressive testing results.
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R
egardless of whether a trader is using a system or some otherdecision-making process, success over the long run will depend onhaving some sort of an edge over other investors. Luck might affectresults in some situations, but experienced, successful traders don’t dependon luck. Each day, traders put their money on the line, and they are competing with millions of others who are doing the same. Their money lost issomeone else’s gains. If you lose, they win. If you win, they lose.Only by having superior knowledge, skill, an effective system, or superior trading prowess can one consistently bring in steady profits fromthe financial markets. Luck, guesswork, or hunches will not bring aboutsuccess. The key is having an edge over the competition and also havingthe discipline to follow an intelligent game plan. We teach investors strategies and rules that can help them to generate profits trading stocks andoptions. The students who are successful early in their trading careers areoften the ones who adhere to the rules. Yet it is also human nature to wantto test the rules—to experiment.A good way to experiment or test the water is by trading on paperrather than with real money. (Paper trading is covered thoroughly inChapter 16). System backtesting and development is also enlightening, atopic covered in the previous chapter. In this chapter, we explore a different approach to understanding the financial markets by exploring seasonal trends and a variety of proven technical indicators that can also givetraders an edge when moving through the financial battlefield known asthe index market.
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VOLUMETrading volume is perhaps the single most important indicator used intechnical analysis. We discussed it briefly in the first few chapters of thisbook. Recall that when an investment is rising in value as volume increases, it suggests that buyers are actively bidding the price higher andshorts are running for cover. Strong volume during an advance is considered a bullish sign. In contrast, when volume swells during a decline,bears are driving prices lower, bulls are in pain, and the action of thestock is considered poor. Studying volume gives the analyst a better senseof whether the bulls or bears are in control of the stock.What exactly is volume? In the stock market, volume is the total number of shares associated with a specific stock or market. Also known asturnover, it reflects the number of shares bought or sold relative to a specific security over a specific time frame. For instance, if you purchase 100shares of Microsoft, the volume of that trade is equal to 100.When looking at the performance of “the market,” we usually look atthe performance of the Dow Jones Industrial Average ($INDU) along withthe total volume on the New York Stock Exchange. When monitoring theNASDAQ Composite Index ($COMPQ), we watch the total volume on theNASDAQ Stock Market. For example, a news reporter might say that theDow Jones Industrial Average rose 83 points on 2.1 billion shares. The total volume of 2.1 billion shares is the total amount of trading on the NYSEthat day, which includes all of the volume for all of the stocks listed on theexchange.The Dow and Dow VolumeMarket watchers often view the performance of the Dow Jones IndustrialAverage alongside the total New York Stock Exchange (NYSE) volume. Forinstance, a ﬁnancial reporter will say that the Dow rose x number of pointson y amount of volume, where the volume refers to the NYSE total volumefor that day. However, this is a bit misleading for two reasons. For one, theDow now includes two NASDAQ stocks—Intel (INTC) and Microsoft (MSFT).Second, while the Dow consists of only 30 stocks, thousands of differentstocks trade on the NYSE. Therefore, a more accurate view of price actionand volume in the stock market would be to plot the performance of theNYSE Composite Index ($NYA), which is an index that includes all stockstrading on the exchange, along with NYSE total volume.
An important maxim regarding volume, according to John J. Murphyin his book, Technical Analysis of the Futures Markets (New York: New
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York Institute of Finance, 1999), is that “Volume should increase or expand in the direction of the existing trend.” When looking at volume by exchange, the strategist wants to see increasing volume occur during theadvances. This will not always happen during a legitimate advance, butwhen it does, increasing volume can serve to confirm the trend.For instance, Figure 10.1 shows volume on the NYSE increasing onthe Dow Jones Industrial Average as it begins to move higher in late 2004.This is a sign that buying pressure is increasing and a bullish sign for theDow. Pullbacks should be on lighter volume if the stock is trending upwards. In addition, during declines one would expect moves lower to beaccompanied by higher volume and for rallies to come on lower volume.
Up versus Down VolumeWhen looking at volume by stock exchange, technicians often break volume down into up volume and down volume. Up volume refers to the volume for those issues on the stock exchange that are moving higher inprice. Down volume is the amount of volume associated with stocks thatare falling or declining in price that day.For example, if total volume on the NYSE on Wednesday is 1.5 billionshares, and up volume totals 1.2 billion while down volume equals 300million, the ratio of up to down volume is four to one, positive. This is asign of strong buying pressure and, from a technician’s viewpoint, is a positive sign. It is an indication of market strength. The same analysis can beapplied to NASDAQ trading.
FIGURE 10.1 Dow Jones Industrials and NYSE Volume (Source: www.ProﬁtSource.com)
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Table 10.1 shows a breakdown of the up and down volume by exchange for the first week of November in 2004. It is the same periodhighlighted in Figure 10.1. Notice during that time, the Dow was movinghigher. The table shows that Wednesday’s and Thursday’s combinedmarket action resulted in a gain of 279 points in the industrials. At thesame time, volume on the New York Stock Exchange rose, from 1.4 billion shares on Monday, to an average of nearly 1.8 billion on Wednesdayand Thursday.While total volume started rising during the second half of the week,up volume jumped to more than 1.4 billion on those two days compared to320 million shares of down volume. Therefore, the up to down volume statistics were extremely bullish during this period. In addition, the fact thatvolume jumped on this upward move after a previous two-month declineindicates that buying pressure was building and stocks were reversingtrend. If the rally had occurred on low volume, one might have assumedthat the market was still in a downtrend. However, that was not the caseduring the first week in November 2004.While a similar story was unfolding on the NASDAQ, the up to downvolume also reveals that NYSE stocks were seeing a much better ratio ofup to down volume. For instance, on Wednesday, up volume beat downvolume on the NYSE by a margin of more than four to one. On the NASDAQ, the margin was less than two to one positive. Therefore, the buyinginterest in NYSE stocks was much stronger than in NASDAQ stocks atthat time.
TABLE 10.1 NYSE and NASDAQ Up and Down VolumeMonday(11/1)
Tuesday(11/2)
Wednesday(11/3)
Dow Jones10,054.39 10,057.41 10,137.05Industrial Average+26.92+3.02+101.32Total Volume (000s) 1,397,000 1,666,000 1,773,000NYSE Up Volume719,000830,000 1,428,000NYSE Down Vol.657,000801,000321,000NASDAQ1,979.871,987.86 2,004.33+4.88+7.99+19.54Total Volume (000s) 1,552,000 1,444,000 1,964,000NASDAQ Up Volume983,000968,000 1,116,000NASDAQ Down Vol.530,000466,000822,000
Thursday(11/4)
Friday(11/5)
10,314.76+177.711,799,0001,450,000322,0002,023.63+19.301,826,0001,170,000604,000
10,387.54+72.781,729,0001,101,000595,0002,038.94+15.311,899,0001,363,000517,000
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ETFs and Trading VolumeTraders can also use volume for analysis when trading exchange-tradedfunds (ETFs); it is the same as with stocks. Namely, the volume refers tothe volume by symbol rather than the volume for a single exchange. So,when looking at the volume of an index like the Dow and the NASDAQ,the volume represents the volume by stock exchange. When looking atvolume for exchange-traded funds, the volume is equal to the sharestraded of that ETF alone (see Figure 10.3).
Blow-Off Tops and BottomsSometimes volume will surge at important turning points for the market—a phenomenon analysts refer to as a “blow-off.” This can occur after a precipitous advance. It’s called a “selling climax” and it’s more commonduring downtrends after a surge in selling pressure. Figure 10.2 shows aselling climax in September 2001. Obviously, the news was terrible at thetime. Nevertheless, it served as an important turning point as many bearswere washed out of the market.
FIGURE 10.2 Dow Jones Industrials Blow-Off Bottom (Source: www.ProﬁtSource.com)
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FIGURE 10.3 QQQQ and Rising Volume (Source: www.ProﬁtSource.com)
FIGURE 10.4 Falling QQQQ and Rising Volume (Source: www.ProﬁtSource.com)
During a downtrend, volume will increase when the Qs move lowerand diminish during rallies. Often an advance will end when volumedeclines and the index begins to trade lower. Then, increasing volume willsignal a change in trend. Figure 10.4 shows the rally in the Qs faltering inJanuary. Notice that volume started to rise as the index broke below itsDecember lows. In sum, strategists want to consider volume along withprice