8 46.15Crude oil 42.17 40.45 45.45 43.02 44,71Soybeans 45.33 47.05 52.16 49.77 47.50
Figure 5-7. Day-of-week close greater than open relationships in selectedmarkets.Day of the Week Patterns 73
 
 
jb.0B0 System S&P 500 INDEX 55/99-Daily 04/21/82 - 01/09/98
Total net profitGross profit
Total # of tradesNumber winning trodes
Lorgest winning tradeAverage winning tradeRatio avg win/avg loss
Max consec. winnersAvg # bars in winners
Performance Summary: All Trades
$ 162500.00 Open position P/L $ 0.00
$ 429000.00 Gross loss $-266500.00397 Percent profitable 11h307 Number losing trades 90
$ 39425.00 Largest losing trade $ -5725.00$ 1397.39 Average losing trade $ -2961.110.47 Avg trade(win & loss) $ 409.32
21 Max consec. losers 42 Avg # bars in losers 2
Max intraday drawdown $ -27325.00
Profit factorAccount size required
1.61 Max # contracts held 1$ 27325.00 Return on account 595%
 
Figure 5-8. The DBO method in S&P 500 futures—historicalrecord. Long entry, three ticks, above Friday's high; shortentry, 26 ticks, below Friday's low. Stop loss $3400. Exit onfirst profitable opening. (Reprinted with permission of OmegaResearch™.}
it dual breakout or DBO. The DBO is a method that buys or sellsonly on given days of the week based on a breakout above orbelow the previous daily high or low and on the open/close rela-tionship of the previous day. This method shows a high degree ofaccuracy; however, it requires you to hold your position until thefirst profitable opening. In S&P 500 futures this means holdinguntil the next day’s opening. See Figure 5-8 for an example of theDBO history on Mondays (or the first trading day of the week).
DBO Rules and Parameters
The DBO rules are simple:
= Trade only on the indicated day or week (see historical recordsshown later in this chapter for day-of-week parameters).
= Buy on a stop x ticks above the previous daily high if previousclose was greater than previous open.
= Sell short on a stop x ticks below the previous daily low if previ-ous close was less than previous open.74 = ~~ Chapter Five
jp.0BO System S&P 500 INDEX 55/99-Daily 04/21/82 - 01/09/98
Total net profitGross profit
Total # of tradesNumber winning trades
Largest winning tradeAverage winning tradeRatio avg win/avg loss
Max consec. winnersAvg # bars in winners
Max intraday drawdownProfit factorAccount size required
 
Performance Summary: All Trades
$ 143650.00 Open position P/L $ 0.00$ 398425.00 Gross loss $-254775.00
395 Percent profitable 78%310 Number losing trades 85
$ 11200.00 Largest losing trade  $ -7900.00$ 1285.24 Average losing trade  $ -2997.350.43 Avg trade(win & loss) $ 363.67
18 Mox consec. losers 52 Avg # bars in losers 2
$ -23650.001.56 Max # contracts held$ 23650.00 Return on account
Figure 5-9. DBO signals on Thursdays. Long entry six ticksabove Wednesday's high; short entry 21 ticks belowWednesday's low. Stop loss $3500. Exit on first profitableopening. (Reprinted with permission of Omega Research™.)
= Exit on a predetermined risk management stop loss.= Exit on the first profitable opening (FPO).
I stress that this method requires holding until the first prof-itable opening. Hence, it is not a day trade method, but it’s asclose to a day trade method as possible. As a point of information,it is often possible to exit these trades profitably in the Globexmarket after the official close of U.S. trading. Hence, this methodcan be considered slightly more than a day trade method andslightly less than an overnight method. Remember that, as a rule, Iprefer not to trade on the Globex market, since liquidity is notacceptable at this time. This may change in the future.
Finally, please note that all of the historical tests in this book aresubject to limits inherent in the Omega TradeStation™ softwarewhich was used in my tests. One such limitation is the ability todifferentiate whether a market touched its daily low or daily highfirst. This could be very important in triggering a stop loss or infailing to do so. While the software is designed to test for suchDay of the Week Patterns 75
 
jb.080 System S&P 500 INDEX 55/99-Doily 04/21/82 - 01/05/98
Performance Summary: All Trades
Total net profit $ -1700.00 Open position P/L $ 0.00Gross profit $ 311800.00 Gross loss $-313500.00Total # of trades 385 Percent profitable 68%Number winning trades 260 Number losing trades 125
Largest winning trade $ 9375.00 Largest losing trade  $ -3925.00Average winning trade $ 1199.23 Average losing trade $2508.00
Ratio avg win/avg loss 0.48 Avg trade(win & loss) $ © -4.42Max consec. winners 13 Max consec. losers 5Avg # bars in winners 2 Avg # bars in losers 2Max intraday drawdown $ -39100.00
Profit factor 0.99 Max # contracts held 1Account size required  $ 39100.00 Return on account -4h
 
 
 
Figure 5-10. The Wednesday DBO. Note that using the DBOmethod on Wednesdays {i.e., referenced to Tuesday's range) isa losing proposition in spite of its 68 percent accuracy from1982-1998! This clearly shows that the day of the week is veryimportant. (Reprinted with permission of Omega Research™.)
cases, it is not perfect. Hence, the results in these tests may containsome minor inaccuracies due to the limitations of the software.
DBO on an Intraday Basis
The DBO method can be adapted and applied to intraday trading.My research in this area is still in process, but the initial results arepromising. Rather than use a day of the week as the referencepoint or bar, a given hour or half hour of the day could be used(i.e., similar to the 30MBO method).
Summary
Historical and statistical research confirm the existence of date andday-of-week patterns. Some of these patterns have shown a highprobability of repetition over many years. By combining the day-of-week and/or date seasonals with timing and risk management76
Chapter Five
rules, valid systems can be developed based on these patterns. Attimes, holding a trade overnight or until the first profitable openingwill yield better results than holding only until the end of the daysession. Keep in mind that risk management of these trades is just asimportant as it is for all methods and systems discussed in this book.Trading Systems
Pros and Cons
Even God cannot change the past.AGATHON
In my years of trading, I have met essentially four types of traders:the purely technical trader, the purely fundamental trader, thetechno-fundamental trader, and the intuitive, seat-of-the pants,guts-and-glory trader.
The Purely Technical Trader
Although there are relatively few traders who are pure markettechnicians, there is much to be said in favor of such an approach.But being a pure technician should not be taken as synonymouswith being a disciplined trader. Yet the technical approach, as longas it is not subject to interpretation, can be very helpful in the for-mula for successful trading.
The purely technical trader is more concerned with analysis andthe realities of his or her technical indicators than in the news back-drop, the ramifications of politics on the markets, or the emotion oftraders (unless these can all be quantified and expressed as indica-tors). While many traders fancy themselves to be pure technicians,they are, in fact, not as pure as they may imagine themselves to be.
7778 Chapter Six
They allow subtle external influences to creep into their decision-making process in spite of their supposedly technical bent.
The good news for market technicians is that they are apt to bemore disciplined and less subject to the emotional reactions thatare often associated with losses in trading. By remaining focusedon their indicators, they will be less apt to respond to situationsemotionally and, therefore, more likely to trade mechanical sys-tems with strict discipline. Hence, the benefits of being a puretechnician are as follows:
® Clearly defined rules for market entry and exit
® Specific rules for exiting losing trades
= Less likelihood of riding losses beyond their dictated exit points= Greater likelihood of maximizing profits by not exiting too soon
Are there any cons to the use of a purely technical approach?Some traders would have us believe that being a purely technicaltrader ignores the realities of the marketplace. They claim thatinternational and domestic events can, and do, have a majorimpact on price trends and patterns. Hence, they claim that thetechnical trader is like an ostrich with its head in the sand. Thetechnical trader would retort by stating that a good technical sys-tem will anticipate major events, allowing the trader to enterbefore they occur or, at the worst, shortly after they begin. On theother hand, the retort to this claim is that some events, such as cat-astrophic weather or assassinations, cannot be predicted. The tech-nician would reply that in such cases, which are few and farbetween, the system would protect the trader by taking a loss.Hence, risk management “saves” the system trader when the trad-ing method is surprised by unexpected events.
The Purely Fundamental Trader
This type of trader is a rarer breed than the purely technical trader.Why is this so? The simple fact is that fundamentals are muchmore difficult to understand and to find than are technicals.Frequently, only a few insiders who are able to act on their knowl-edge well before the majority of traders have the news know thefundamental changes and conditions that precede or cause majormarket moves.Trading Systems: Pros andCons 79
Furthermore, once a trader has the relevant fundamentals, theymust be interpreted. Interpretation of fundamentals varies fromone individual to the next. A given set of statistics might mean onething to one trader but an entirely different thing to another trad-er. All too often the interpretation of fundamentals is a function ofone’s position. A fundamental trader with a long position will,therefore, be more apt to interpret a bearish report as bullish,while a fundamental trader with a short position will be more aptto interpret a bullish report as bearish. “Talking one’s position,” asthis is called, is not unique to fundamental traders, but it is morecommon, since fundamentals are subject to considerably moreinterpretation than are technicals.
The benefits of being a purely fundamental trader are as fol-lows:
= You will always have a reason or justification for your trade.= Your trades will always make sense.
= If your analysis of the fundamentals is correct, then you'll catchthe major moves.
= When the fundamentals change, you will be able to change yourposition.
Of course, all of the above are predicated on the availability offundamental information and on its correct interpretation once ithas become available.
The Techno-Fundamental Trader
This group of market participants is larger than either the puretechnician or the pure fundamentalist groups. As its name indi-cates, those who follow this method either knowingly or by acci-dent tend to combine technical timing and trend factors with fun-damentals. Hence, when the fundamentals are bullish, the traderwould be on the lookout for technical indicators that correlatewith the fundamentals in order to fine-tune market entry. The jus-tification for this approach (and it’s a reasonable justification) isthat markets do not always respond to fundamental changesimmediately. At times there is a delay in the amount of time ittakes for the fundamentals to sink in or to be assimilated bytraders. Hence, timing in the form of technical signals will help80 Chapter Six
the fundamental trader fine-tune entry. Theoretically, when bothmethods are in conjunction, the odds of success will be greater.The benefits of being a techno-fundamental trader are as follows:
= Timing will ideally complement fundamentals, causing them towork better.
= Timing and fundamentals together comprise the best of bothmethods in trading.
= Trades can be justified and understood on two different levels.
® Your trading will be responsive to world events, as well as totechnical signals.
The Intuitive Seat-of-the-Pants,Guts-and-Glory Trader
Summary
No matter what term you apply to this type of trader, the fact isthat they rarely follow any trading system, method, or indicatorfor more than a few days or weeks. One day they'll be singing thepraises of triple moving averages, and then next day they'll extolthe virtues of the Elliott Wave. Let their pet system of the day orweek take a loss, and the love comes to a crashing end.
Such traders are rarely systematic in anything, tend not to fol-low a plan, tend to act on an emotional or gut level, and tend to beconsistent losers in the markets. But why?
Trading systems are not the panacea to resolving the many limit-ing factors that are part and parcel of futures trading. The goodnews is that a trading system will give you strict rules to follow.The bad news is that most traders will not follow their rules. Andfinally, there can be more bad news if the system you are using hasbeen overly optimized.Power of theInside Day
It is the difference of opinions that makeshorse races. MARK TWAIN
I have stated repeatedly that my work with price patterns hasrevealed many interesting and potentially profitable relationships.Another important pattern is what has been called the inside day(ID). An ID is defined operationally as a day on which the low isgreater than the low of the previous day and the high is lowerthan the high of the previous day. In other words, over a 2-dayperiod, the second day’s trading range falls within the range of thefirst day.
Traders have long conjectured that an ID is indicative of traderindecision and that a change in trend is likely to occur verysoon. Logically this makes good sense. But good sense and logicin the markets do not always translate into profits. Let’s take alook at a pattern that uses the ID concept to generate effectivetrading signals. Note in advance that this pattern deviates slight-ly from the pure day trade concept. I include it here because Ifeel it is an effective pattern, even though it requires holding atrade for slightly more than just the day time frame. In addition,I fee] that the concept has potential if adapted to use on an intra-day basis.
8182
Chapter Seven
High of
Day 2BelowHigh of Day 1
Low of
Day 2
Above
Low of Day 1Day1l Day2
Figure 7-1. Ideal example of the inside day.
Inside Day Example
Figure 7-1 illustrates the inside day pattern. As you can see, it is avery simple pattern that is not only easy to visualize but alsoclearly defined in terms of a model or algorithm.
Figure 7-2 shows a daily chart of T-bond futures (day sessiononly) with the inside days marked by arrows. As you can see, thereare not as many inside days during the course of a 3-month timeframe as one might expect. This is good because it means that sig-nals generated from inside day patterns will not be too plentiful.
Inside Days and Trend Change
It may very well be true that an ID may signal a change in trend.But how can we take advantage of this relationship? One simpleway is to use the high and low of the inside day as trend breakoutpoints for buying on a stop or selling on a stop. The method isactually very simple. After an inside day, buy at the high price ofthe inside day plus x ticks, or sell at the low of the inside dayminus x ticks.
The x ticks’ value will need to be large enough to avoid whip-saw-type trades and small enough to give a sufficient number oftrades. A risk management stop loss would need to be used, andsome other rules would need to be associated with the method. Ifthere is validity to the approach, then the technique should yieldPower of the Inside Day 83
 
Figure 7-2. Arrows denote inside days (ID) in T-bond futures (day session only).
fairly good accuracy in valid markets. The ID breakout methodmodel is shown in Figure 7-3.
Figure 7-4 shows the ID breakout method in practice. I havemarked arrows at the buy/sell and exit points for S&P 500 futures.
Reviewing the Rules
Here is a review of the ID breakout method:
= An inside day ID is required before a signal can be triggered.a After an ID, buy on a stop above the high of the ID plus x ticks.
= After an ID, go short on a stop below the low of the ID minus xticks.
= The optimum number of ticks high for low penetration is a func-tion of the market.
= Use a risk management stop loss.Day |Figure 7-3. The ID breakout method model.
 
paveors7
(S&P 500 INDI EX ESE Daly 0 MRE O=B68.60 +14.09 O=Bsy aes
jf Ye | Ms :
 
aM
  
 
 
 
 
 Power of the Inside Day 85
jb.Inside Bar S&P 500 INDEX 55/99-Daily 04/21/82 - 01/13/98
Performance Summary: All Trades
 
 
Total net profit $ 94505.00 Open position P/L $ 0.00Gross profit $ 379130.00 Gross loss $-284625.00Total # of trades 430 Percent profitable 69%Number winning trades 298 Number losing trades 132Largest winning trade $ 20250.00 Largest losing trade § -5175.00Average winning trade $ 1272.25 Average losing trade $ -2156.25Ratio avg win/avg loss 0.59 Avg trade(win & loss) $ 219.78Max consec. winners 14 Max consec. losers 4Avg # bars in winners 2 Avg # bars in losers 1Max intraday drawdown $ -21350.00Profit factor 1.33 Max # contracts held 1Account size required $ 21350.00 Return on account 443%Performance Summary: Long TradesTotal net profit $ 92055.00 Open position P/L $ 0.00Gross profit $ 224730.00 Gross loss $-132675.00Total # of trades 246 Percent profitable 713%Number winning trades 180 Number losing trades 66Largest winning trade $ 5875.00 Largest losing trade $ ~-4075.00Average winning trade $ 1248.50 Average losing trade § -2010.23Ratio avg win/avg loss 0.62 Avg trade(win & loss) $ 374.21Max consec. winners 14 Max consec. losers 4Avg # bars in winners 2 Avg # bars in losers 1Max intraday drawdown § -13725.00Profit factor 1.69 Max # contracts held 1Account size required $ 13725.00 Return on account 671%Performance Summary: Short TradesTotal net profit $ 2450.00 Open position P/L $ 0.00Gross profit $ 154400.00 Gross loss $-151950.00Total # of trades 184 Percent profitable 64%Number winning trades 118 Number losing trades 66Largest winning trade $ 20250.00 Largest losing trade $ -5175.00Average winning trade $ 1308.47 Average losing trade $ -2302.27Ratio avg win/avg loss 0.57 Avg trade(win & loss} $ 13.32Max consec. winners 9 Max consec. losers 5Avg # bars in winners 2 Avg # bars in losers 1Max intraday drawdown § -31800.00Profit factor 1.02 Max # contracts held 1Account size required $ 31800.00 Return on account 8%
Figure 7-5. Historical record of ID in S&P futures—1982-1998.86 Chapter Seven
Summary
= Exit on the first profitable opening or at the stop loss, whichevercomes first.
With the above rules in mind, note the historical record in S&Pfutures from 1982 to 1998 in Figure 7-5.
An inside day can often indicate that a minor change in trend isimminent. The ID breakout method provides specific parametersfor buying and selling on inside day breakouts. I presented specif-ic rules of application for the ID breakout method. Note that thismethod is not a day trade approach. It requires the trader to holda position until the first profitable opening after entry. Most oftenthis is the very next opening. At times, however, if the trade is notstopped out, you may need to hold the position for a few daysbefore it becomes profitable. The basic approach is highly validand can be adapted to intraday bars within the trading day, at astop loss, or at MOC. Note also the inherent limitations of this testas described on page 74.System Testingand Optimization
Friend or Foe?
The verdict of the world is final.ST. AUGUSTINE
The days of untested systems are gone forever. In fact, the pendu-lum is now swinging in the other direction. While unscrupulousoperators once sold systems and methods for which they claimedfantastic results, today’s unethical operators use statistics as a toolof deception. These individuals who, paradoxically, will benefitfrom the trend toward the statistical validation of systems can eas-ily dupe the public. Manipulating statistics is not difficult. Just asArchimedes once said, “Give me a place to stand on and I canmove the earth,” the modern systems promoter would likely say,“Give me enough statistics and I can prove anything.”
This sermonette on system validation makes the point thatmerely testing a system and generating highly favorable hypothet-ical results does not guarantee success with that system. Norshould such statistics be used as a security blanket or crutch bytraders. Statistics can easily be manipulated, systems can be (andare) curve-fitted, and results, unless realistic, will not reflect actualperformance when the system is implemented.
8788 = Chapter Eight
While many systems are developed to show optimum perfor-mance, it is imperative that systems be tested to show the worst-case performance.
Why Test Trading Systems?
Traders test systems for various reasons. Some test a system mere-ly to say they’ve done so, only to disregard the outcome or toaccept mediocre results, rationalizing the negative aspects of theirsystem. Other traders test systems in order to sell them to the pub-lic—their goal is to optimize systems in order to show maximumperformance. Then there’s the serious futures trader who tests sys-tems to achieve several goals, including but not limited to the fol-lowing:
= To determine whether a theory or hypothetical construct is validin historical testing
= To summarize the overall hypothetical performance of a systemand to analyze its various aspects in order to isolate its strongand weak points
= To determine how different timing indicators interact with oneanother to produce an effective trading system
= To explore the interaction of risk and reward variables (i.e., stoploss, trailing stop loss, position size, etc.) that would havereturned the best overall performance with the smallest draw-down
Test Your Trading System
While it may seem that the last item listed above refers to opti-mization, you will see from the discussion of optimization later inthis chapter that it is not optimization according to my definitionof the term. The purpose of testing systems is simply to find whatwill work best for you based on what appears to have worked bestin the past. In so doing, we must remember that what worked inthe past in hypothetical testing may not necessarily work in thefuture.
A thorough test of your trading system should include at leastthe following information:System Testing and Optimization: Friend or Foe? 89
Number of Years Analyzed. Although it is desirable to test asmuch data as possible, many trading systems and indicators donot withstand the test of time. The further back you test, the lesseffective most systems will be. Many system developers test only10 years of historical data, since that best shows their systems. Youmust make your own decision regarding the length of your test.
Number of Trades Analyzed. More important than the num-ber of years analyzed is the number of trades. You need not ana-lyze many years of data if you have a large sample size of trades. Irecommend at least 100 trades, provided your system will gener-ate this number of trades in back-testing. If you are truly interest-ed in determining the effectiveness of your system, the moretrades you test, the better. Remember that there will always be atendency to test fewer trades when you realize that the system isnot holding up under back-testing. Some traders argue that thefactors underlying futures market trends 25 years ago were dis-tinctly different from those during the past 10 years. They feel thattesting 25 years of data distorts the picture. If they were correct,how would we know when the current market forces change.andthat we must therefore change our trading systems? We are muchbetter off finding systems that work in all types of markets.
Maximum Drawdown. This is one of the most importantaspects of a trading system. A very large drawdown is a negativefactor, since it eliminates most traders from the game well beforethe system would have turned in its positive performance.Because most traders are not well capitalized, they cannot with-stand a large drawdown. However, drawdown is a function ofaccount size. Obviously, a $15,000 drawdown in a $100,000account is not unusual; however, the same drawdown in a $35,000account is serious. You may decide to risk large drawdown inorder to achieve outstanding performance, but this is your deci-sion.
Consider also the source of the drawdown by examining thelargest losing trade. If the majority of the drawdown occurred ononly one trade, you will be better off than if the drawdown wasspread out over numerous successive losses.
Maximum Consecutive Losses. This performance variable ismore psychological than anything else is. An otherwise excellenttrading system may have lost money on many trades in succession.90
Chapter Eight
Few traders can maintain their discipline through four or moresuccessive losing trades. Even after the third loss, many traders areready to either abandon their system or to find ways of changing it.However, at times it is necessary to weather the storm of 10 ormore successive losses. If you know ahead of time what the worst-case scenario has been, you will be prepared. That’s why it’simportant for your system test to give you this information.
Largest Single Losing Trade. This important piece of infor-mation indicates how much of the maximum drawdown is theresult of a single losing trade. And this allows you to adjust theinitial stop loss in retesting the system so as to see how large theaverage losing trade has been. If the average losing trade, forexample, was $1055 and the largest single loser was $8466, youcan readily see that a good portion of the average losing trade wasa function of the largest loser. This shows that if you had a betterway of managing the large loser (in hindsight, of course), youroverall system performance would have been considerably better.
I strongly recommend close examination of the trade that result-ed in the single largest loss if this loss is clearly much higher thanthe average losing trade. Another question to ask is “Why was thelargest single losing trade so much larger than the stop loss select-ed?” A single largest losing trade that is several times larger thanyour selected stop loss points to a potential problem, perhaps withthe system test. You must investigate further in such cases.
Largest Single Winning Trade. Perhaps more important thanthe largest single losing trade is the largest single winning trade. If,for example, your hypothetical profits total $96,780, and $33,810 ofthis is attributed to only one trade, you have a distorted averagetrade figure. It’s often a good idea to remove this one trade fromthe overall results and recompute them in order to show the per-formance without this extraordinary winner. You may find that thesystem you have tested is mediocre, perhaps even a loser, when thesingle largest trade has been eliminated from the performancesummary. If you can wait 10 years for the one big trade, then usethe system—but do so against my advice. What you're looking forin any system with regard to average winning and losing trades isconsistency—far more important than one or two extremely largewinning trades that give a distorted performance picture.
On occasion only several trades may account for a considerableportion of the net system profits. While some traders feel that thisSystem Testing and Optimization: Friend or Foe? 91
somehow diminishes the value of the system, I disagree. As longas at least one-half of the overall system performance is due totrades other than the largest single winning long and short tradecombined, the system is valid. As far as numbers are concerned, Iwould not use any system that, after deducting reasonable slip-page and commission as well as the largest single long and shortwinners, does not show at least $100 average profit per trade.
More importantly, because a large portion of profits in manysystems derives from a very small number of trades, it is impera-tive that you follow each and every trade as closely to the rules aspossible. Trading systems are not money machines; they don’tgrind out one profit after another. Trading systems make theirmoney on the bottom line. There are many losers and few win-ners. The losers are kept in check by using money managementstop losses that must, in most cases, be reasonably large.
And the winners, only a few of which are very large, make thegame worth the candle. The trader who can’t stick with a position,or let it ride, is the trader who will be sorely disappointed with theresults, because the big winners will be cut short.
Later in this book I will make a case for systematic market entryand less rigid market exit. Bear in mind, however, that when thisprocedure is followed, you must stick with the original system asclosely as possible for market entry. Such adaptations are recom-mended for the skilled trader only!
Percentage Winning Trades. This statistic is not nearly asimportant as one might think