<s> QUANTITATIVETRADING STRATEGIESHarnessing the Powerof Quantitative Techniques toCreate a Winning Trading Program
Other books in The Irwin Trader’s Edge SeriesTrading Systems That Work by Thomas StridsmanThe Encyclopedia of Trading Strategies by Jeffrey Owen Katz andDonna L. McCormickTechnical Analysis for the Trading Professional by Constance BrownAgricultural Futures and Options by Richard DuncanThe Options Edge by William GallacherThe Art of the Trade by R.E. McMaster
QUANTITATIVETRADING STRATEGIESHarnessing the Powerof Quantitative Techniques toCreate a Winning Trading Program
LARS N. KESTNER
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To my parents, Neil and Arlene Kestner:All your support has made me the person I am todayAll of the author’s proceeds from this book will bedonated to the Windows of Hope Family Relief Fund.The Windows of Hope Family Relief Fund providesaid, future scholarships, and funds to the familiesof victims who worked in the food, beverage, andhospitality professions at the World Trade Center.
ACKNOWLEDGMENTS
I
wish to thank many individuals who both directly and indirectly led to the creationof this book:My parents, Neil and Arlene, have always challenged me to pursue mydreams—however lofty those dreams might be.I am grateful to Kristen, who put up with a lot of late stressful nights whileI was writing this book.Many thanks to my friends who, over the years, have helped shape both mycareer and my thoughts on the markets: Andy Constan, Scott Draper, Leon Gross,Ken Mackenzie, Bryan Mazlish, and Josh Penner. A debt of gratitude also goes toThom Hartle, former editor of Stocks and Commodities magazine, for publishingsome early work from an over-achieving 19-year-old. That publication gave meconfidence to take my ideas and research much further. In addition, I must thankScott Bieber and Nick Cicero for editing early versions of this manuscript andadding constructive criticism. Also invaluable were Stephen Issacs and Scott Kurtzof McGraw-Hill for taking a very rough set of ideas and turning them into a wonderfully crafted text. Final gratitude goes to my cats Thomas and Grey, who, withall their steps on my laptop’s keyboard late at night, are probably owed some portion of the copyright as coauthors.
Copyright 2003 by Lars Kestner. Click Here for Terms of Use.
For more information about this title, click here.CONTENTS
ACKNOWLEDGMENTSPROLOGUE XIII
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PART ONESTRUCTURAL FOUNDATIONS FOR IMPROVING TECHNICALTRADING PERFORMANCE 1Chapter 1Introduction to Quantitative Trading: How Statistics Can Help AchieveTrading Success 3Trading Strategies and the Scientific Method 3The Origins of This Book 5New Markets and Methods of Trading 6The Scientific Bent and Quantitative Trading 6The Pioneers of Quantitative Trading: W. D. Gann, Richard Donchian,Welles Wilder, Thomas DeMark 9The Recent Explosion of Quantitative Trading 10Today’s Quantitative Traders: Monroe Trout, John Henry, Ken Griffen,Jim Simons 11Why Quantitative Trading Is Successful 14Birth of a New Discipline 21Technology and Inefficiencies in Financial Markets 30Merits and Limitations of Fundamental Analysis 33
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Chapter 2An Introduction to Statistics: Using Scientific Methods to Develop CuttingEdge Trading Strategies 39Measuring the Markets Using Statistics 39Mean and Average of Returns and Prices 40Measuring the Dispersion of Returns 40Correlation 42The Usefulness of the Normal Distribution 46The Irregularity of Market Volatility 49The Range of Volatilities 50The Lognormality of Market Prices 53Chapter 3Creating Trading Strategies: The Building Blocks That Generate TradesThe Need to Explain Price Changes 55Trading Strategy Entries 56Trend Following Techniques 56Moving Averages 57Channel Breakouts 60Momentum 62Volatility Breakouts 63Price Oscillators 66Relative Strength Index 66Stochastics 66Moving Average Convergence/Divergence 68Price Patterns 69Trading Strategy Exits 69Profit Targets 70Trailing Stops 70Fail Safe Exits 72Trading Strategy Filters 72Creating New Strategies: Quantifying Rules from Trading TheoriesThe Need forTrading Systems and a Trading Plan 73
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Chapter 4Evaluating Trading Strategy Performance: How to Correctly AssessPerformance 75Popper’s Theories Applied to TradingFlaws in Performance Measures 76
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Net Profit 76Profit Factor 78Profit to Drawdown 80Percent of Profitable Trades 82Better Measures of Trading Performance 84The Sharpe Ratio 84The K-Ratio 85Comparison of Benchmark Strategies 90Performance Evaluation Templates 90Summary Page 90Breakdown Statistics 94The “Half Life” of Strategy Performance 94What to Do When Strategies Deteriorate 97Gold Mines of Bad Performance 97Other Testing Methods 98The Fallacy of Magical Thinking 98Chapter 5Performance of Portfolios: Maintaining Returns While Decreasing RiskThe Lessons Learned from a Casino 99The Benefits of Diversification 100Don’t Put All Your Eggs in One Basket 102The Best Diversification: Across Markets 104Better Diversification: Across Uncorrelated Strategies 105Good Diversification: Across Parameters Within Strategies 106The Trader’s Holy Grail 107Chapter 6Optimizing Parameters and Filtering Entry Signals: Improving theBasic Strategy 109Optimizing Trading Signals to Enhance Profitability 109Optimization Versus Curve Fitting 110Measuring the Value of Optimization 112Filtering to Enhance Profitability 117Similarities of Trade Filters: ADX and VHF 117Measuring the Value of Filtering 117Regime Switching Strategies 118Filtering Using the Profitability of the Last Trade 121
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Trading the Equity Curve 123How Often Do Markets Trend? 124PART TWOHARNESSING THE POWER OF QUANTITATIVE TECHNIQUES TOCREATE A TRADING PROGRAM 127Chapter 7Dissecting Strategies Currently Available: What Works andWhat Doesn’t 129Testing Stocks and Futures Markets 129Constructing Continuous Futures Contracts 130Normalizing Stock and Futures Volatility 133Dealing with Commission and Slippage 139Performance of Popular Strategies 139Channel Breakout 139Dual Moving Average Crossover 145Momentum 150Volatility Breakout 155Stochastics 155Relative Strength Index 165Moving Average Convergence/Divergence 170A Baseline for Future Trading Strategies 175Chapter 8New Ideas of Entries, Exits, and Filters: Enhancing Trading PerformanceUsing Cutting Edge Techniques 181A Wolf in Sheep’s Clothing 181The Song Remains the Same: Similarities of Oscillators11 New Trading Techniques 182Kestner’s Moving Average System 183Second Order Breakout 183MACD Histogram Retracement 191Divergence Index 197Moving Average Confluence Method 202Normalized Envelope Indicator 208Multiple Entry Oscillator System 213Adjusted Stochastic 219Three in a Row 222
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Volume Reversal Strategy 227Saitta’s Support and Resistance StrategyThe Value of Stop Loss Exits 236Pyramiding vs. Profit Taking 242New Trend Filters 243
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Chapter 9New Ideas of Markets: Trading Doesn’t End with Stocks and FuturesThe World of Relative Value Trading 247Pure Arbitrage 248Bottom-Up Relative Value 249Top-Down Relative Value 250Macro Trading 250Introducing Relative Value Markets 251Yield Curve Markets 251Credit Spreads 253Equity Volatility 257Relative Performance of Stock Indices 259Single Stock Pairs 263Commodity Substitutes 264Stock and Commodity Market Relationships 265Developing Strategies for Relative Value Markets 266Applying Quantitative Trading Strategies to Relative Value MarketsChannel Breakout 269Dual Moving Average Crossover 269Momentum 269Stochastics 272Relative Strength Index 272Difference from 100-Day Moving Average 277Difference Between 10- and 40-Day Moving Average 280New Markets, New Opportunities 283Chapter 10Investing in the S&P 500: Beating a Buy and Hold Return UsingQuantitative Techniques 289The Popularity of Equities 289The Importance of Interest Rates in Predicting Equity PricesTesting Medium-Term Strategies 294Short-Term Trading Methodologies 295
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Index Funds and ETFs 295Day of Week and Day of Month Effects 297Using the Volatility Index to Trade the S&P 500
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Chapter 11New Techniques in Money Management: Optimizing the Results of OurStrategies 305The Importance of Money Management 305The Relationship Between Leverage and Returns 306The Danger of Leverage 311Leverage and the Trader with an Edge 311Leverage and the Trader with No Edge 312Leverage in the Real World 313The Kelly Criteria 315Vince’s Optimal f 316An Improved Method for Calculating Optimal LeverageThe Role of Dollar and Percentage Returns 316The Paradox of Optimal Leverage 319
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Chapter 12Solving the Trading Puzzle: Creating, Testing, and Evaluating a NewTrading Strategy 321Creating the Strategy 321Testing the New Strategy 324Determining Optimal Leverage 325IN CONCLUSIONINDEX 331
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PROLOGUE
O fortune,Variable as the moon,You ever wax and wane;This detestable life now maltreats us,Then grants us our wildest desires;It melts both poverty and powerLike ice.—from the scenic cantata Carmina Buranaby Carl Orff (1895-1982), translated byLucy E. Cross
My Reasons for Writing This BookLike the quote above, this book is about risk. The focus of this book is to developtrading strategies that buy and sell financial assets while managing the risk associated with these positions. While we have no idea if our next trade will be a winneror loser, by using quantitative tools to identify reward and risk, we can diminish riskwhile maintaining expected gains. This is the key to long-term trading success.Most of the tools in this book have been studied over the past 50 years by academics and have been employed by Wall Street professionals over the past 20 years.Unfortunately there has been a gap when it comes to explaining and teaching thesetechniques to the investing public. This book attempts to fill that void by presenting the advanced concepts in systematic trading, risk management, and moneymanagement that have long been missing.First and foremost, this book explores the ability of quantitative tradingstrategies to time the markets. Quantitative trading strategies are a combination oftechnical and statistical analysis which, when applied, generate buy and sell signals.xiii
Copyright 2003 by Lars Kestner. Click Here for Terms of Use.
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These signals may be triggered either through price patterns or values of complexindicators calculated from market prices. Once these trading strategies are formed,their performance is tested historically to validate the trading ideas. Essentially, wedetermine if a strategy has worked in the past. If a strategy has generated profitshistorically, this gives credence to future performance. After the performance istested, we select the markets to be traded. By trading a widely diversified portfolio, we are able to minimize our risk while maintaining expected reward.Developing the idea, testing historical performance, and picking markets to tradeare a few of the many techniques required for efficient and profitable tradingstrategies. While a few books have touched on various areas of the developmentprocess, I believe this book is the first to fully capture all the nuances of the trading process. While some books provide anecdotal evidence based on one or two ofthe author’s experiences, this book backs up concepts with theoretical explanation,real life results, and references to academic research. My goal in writing this bookis to set the record straight with time-tested statistics—not with untested theoriesand market lore passed down through the ages.A New Approach for Analyzing MarketsThere are numerous methods being used to analyze the markets. Most investorsand traders will look at fundamental data to assess whether they believe the market is going to move higher or lower. In the equity markets, investors will look atearnings, product sales, and debt loads to determine a company’s fair valuation. Acomparison of this valuation to business prospects then determines a fair valuationfor the company. In commodities, investors will look at trends in supply anddemand. Poor weather conditions can hurt a crop outlook and raise prices. Lack ofend demand during a recession can cause prices to fall. Studying these fundamental factors is the most common method of analyzing markets.Another growing method of analysis is technical analysis. Technical analysisdoes not attempt to predict market movements based on fundamentals. Instead,technical analysts believe that one market participant, however well informed, isunlikely to have better information than the combination of all other market participants. As a result, technical analysts believe that price action is the best sourceof information. Market forecasts are made using chart patterns, most of whichhave been studied over decades. Catchy names such as “head and shoulders top,”“symmetrical triangle,” and “trendline” are a large part of the technical analyst’stoolbox. Typically, the technical analyst relies on a good bit of discretion for his orher trading ideas. While a pattern may look like a buy signal to one technical analyst, another may see a different pattern emerging and actually be preparing to sellthe market.This book takes a somewhat different approach than relying solely on fundamental or technical analysis. While most of the strategies studied in this book usepast prices to predict future prices (as would a technical analyst), every strategy is
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specifically defined using rigid rules. This quantitative process removes the subjectivity from which both fundamental and technical analysts suffer. Once strategiesare defined using sound statistical properties, they are thoroughly tested on historical prices to determine profitability over past years. Only ideas that have stood thetest of time will be considered for real-time trading. One benefit of historical performance testing is that traders are more likely to have confidence during poor trading performance when years of theoretical backtesting have shown that the strategybeing traded is viable and profitable.Creating, Testing, and Implementing a Quantitative Trading StrategyOne recurrent theme in this book is the absolute need to test theories. Hours ofdebate may not be able to settle differences of opinion over literature or politics.In these very imprecise subjects, there are no constant truths. There are no definite answers. Should we increase government spending to restart the economy orshould we pay down debt to lower interest rates? Was John Steinbeck or WilliamFaulkner or someone else the best American-born author? No amount of study willlead us to definitive answers.The subject matter of this book, which I call quantitative trading, does notsuffer from this same fate. Whenever we make statements about the market, wecan perform mathematical and statistical tests to determine if we are correct in ourbeliefs. Do changes in interest rates affect returns on the stock market? If cornprices have been rising, is it likely that they will continue to do so in the nearfuture? Considering that historical data for market prices is available back to theturn of the twentieth century in many cases, we can study historical market pricesand usually find answers to these questions once we quantify each of these questions. Answering questions usually comes down to creating a mathematical or statistical test and then analyzing the results. The remainder of this book will attemptto answer questions aimed at understanding exactly how markets behave and howinvestors and traders can profit from this information.Most of our study involves creating, testing, and applying trading strategies.A trading strategy (also called a trading system or trading methodology) is a set ofrules that signal the trader when to buy, when to sell, and when to sell short a market. The buy and sell decisions are typically generated by price patterns and indicators. These strategies can be very simple such as buy on Wednesday and sell onFriday. The signals can also be very complex and include statistical regression andrelationships between many related markets. One positive is that many of the mostprofitable trading systems over the past twenty years are actually very simple innature. Most of the concepts in this book are simplistic and require no more thana high school math background to understand.Another important component of the trading system development process isthe ability to change the values we input into our rules. For example, we mightbuy if today’s close is greater than the close 10 days ago. We can vary the 10-day
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lookback period in an attempt to improve performance. The procedure of changing parameter values to improve performance is called optimization.The most vital part of trading system development is performance testing.When we test historical performance, we first want to see if our strategies have beenprofitable in the past. Because many strategies will be profitable historically, weneed a methodology to compare the profitability among trading strategies. Veryoften the most profitable system is not the best system for our trading. In fact, Ibelieve most traders use outdated and inconsistent performance measures to evaluate historical performance. For this reason we will use superior measures such asthe Sharpe Ratio and K-Ratio for our performance evaluation.Finally, we need to develop a money management plan for trading our strategies. With leverage so readily available through the futures markets and marginstock accounts, we need to quantify exactly how much leverage is ideal, makingsure not to cross over this threshold into trading too aggressively. While this topicsounds very basic, some of the brightest and largest money managers in the worldhave suffered tremendously by not adhering to money management rules.The Wide Spectrum of Markets Available for TradingOnce we have designed and tested our trading strategy, the next choice is todecide which markets to trade. The choices these days are enormous and includestocks, exchange-traded funds, futures, and other markets. Our quantitative trading strategies are applicable to each. The beauty of quantitative trading is the easeof applying a predefined set of rules to multiple markets. The incremental effortof applying a strategy to one additional market is negligible. Just turn on the computer and in seconds the strategy spits out buy, sell, or flat. With technology thesedays, it would be entirely possible for one person alone to trade hundreds, if notthousands, of markets.This book will focus on three distinct markets: stocks, futures, and relativevalue markets. Stocks represent a claim on the assets of a company after allcreditors such as banks and bondholders are paid in full. Shares of companiestrade on three major markets in the United States: the New York Stock Exchange(NYSE), the American Stock Exchange (AMEX), and the NASDAQ. While theNYSE and AMEX are physical trading floors where buyers and sellers meet totrade shares, the NASDAQ is a linkage of market makers negotiating prices withcustomers and with each other. Stocks can be bought, sold, and sold short. If wethink a stock is going to gain, we buy shares in anticipation of selling them at ahigher price in the future. If we think a stock is going to decline, we sell a stockshort. To sell a stock short, your broker borrows shares from another client andsells them on your behalf, and you hope to buy the shorted shares back at alower price.Futures contracts are traded on financial, agricultural, petroleum, and otherproducts. The futures markets were originally devised as a means for suppliers and
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end users to hedge risks associated with their business. For example, a farmerplanting corn cannot sell this corn on the market. The corn must grow, be harvested, and then processed before being sold. Prices might change dramaticallybetween the time of the corn being planted and when it is sold at the market. Thisrepresents a large risk to the farmer whose revenue depends on the price of cornat the time of final sale. Similarly, a food company who needs corn to produce itsbreakfast cereal is also exposed to changes in corn prices. Futures markets areintended to allow both the producers and users of a product a means to hedge. Acorn contract is an obligation to buy or sell a set amount and grade of corn at somepoint in the future. In June, the farmer we spoke of might sell 10,000 bushels ofcorn deliverable in September to lock in his selling price at harvest time. The cerealcompany, knowing that they will be buying corn in the future for their products,might buy 100,000 bushels of September corn in order to lock in their costs. Dueto the high leverage and low transaction costs associated with the futures market,these markets have long been a popular trading vehicle for quantitative traders.Much like stocks, futures can be bought, sold, and sold short.In most books on trading, the variety of markets usually ends at stocks andfutures. In this book we will take quantitative trading one step further by applyingour strategies to some newer markets that are actively traded by hedge funds andWall Street trading desks. While markets such as yield curve spreads, creditspreads, volatility, stock pairs, and commodity substitutes may seem esoteric tomost individual investors, billions of dollars are traded everyday in these products.Most of these markets are actually combinations of other markets where one assetis bought and the other asset is sold short. For example, a popular trade is to buythe 30-year Treasury Bond and sell the 5-year Treasury Note when the yield curveis steeply upward sloping. By combining two or more assets, we can create pricedata for these “relative value” markets. Once we design and test our quantitativetrading strategies, we can implement them on these new markets to gain access toproducts outside the typical stock and futures markets. There is truly no limitto quantitative trading. Give a quantitative trader some price data and he can develop a trading strategy. Whenever new markets are created in the future, quantitative traders will be there to profit.Exploring the Possibilities and Limitations of Quantitative TradingThe Efficient Markets Hypothesis (EMH) is an academic theory which states that,on some level, it is impossible to successfully time the market consistently. Threeforms of the EMH exist: strong form EMH, semi-strong form EMH, and weak formEMH. The strong form of EMH suggests that all information, both public and private, is always incorporated into current prices. The last price reflects all information including unannounced crop reports, yet-to-be-released company earnings,and even the merger that is currently being negotiated between Company ABC andCompany XYZ. The semi-strong form of the EMH states that current prices reflect
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all information in the public domain, including annual company reports, USDA cropestimates, Wall Street research reports, and quality of corporate management. Theweak form EMH suggests that prices already reflect all information that can bederived from analyzing historical market data, such as closing prices, volume, andshort interest.All three forms of the EMH (strong, semi-strong, and weak form) suggestthat our attempts to make money by buying and selling based on prior price patterns are hopeless. While the EMH was widely accepted in the 1970s and 1980s,recent research has found cracks in its premise. Both academic and industryresearch have detected that some inefficiencies continue to persist over time. Forexample, buying stocks that have underperformed over the past three years tend tooutperform for the three years following. Some price patterns can significantlypredict future returns. Certain strategies which follow trends produce consistentresults when traded on a basket of futures markets. These cracks in the EMHhint that markets may not be as efficient as was once thought. Perhaps our quantitative trading strategies can accurately detect and exploit certain patterns that areconsistently profitable.The idea of using quantitative trading strategies is not new. Large institutional money managers such as John W. Henry & Company, Trout Trading andManagement Company, Citadel Investment Group, and Renaissance Technologies have been using these strategies for years with great success. Their fundsare widely considered the best of the best. The rest of this book will attempt tocreate a trading program that comes close to attaining the astonishing results ofthese large money managers.Lars KestnerMay 2003
QUANTITATIVETRADING STRATEGIESHarnessing the Powerof Quantitative Techniques toCreate a Winning Trading Program
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PART
ONE
Structural Foundations for ImprovingTechnical Trading
I
n the first half of Quantitative Trading Strategies we’ll be taking a close look atcurrent techniques used in quantitative and technical trading. This half will introduce basic concepts as well as some of the more advanced techniques that systematic traders use in day-to-day operations. In the second half of the book, using thisfoundation, we’ll go on to study more complex and cutting edge trading methods.We’ll begin with a discussion on the origins of quantitative trading and itsevolution to modern day application. To trade effectively, it’s necessary to understand how markets react on a daily basis, and to be able to isolate tendencies suchas average price, volatility, and relationships to other markets. To this end, we willalso study the statistics and basic properties of market behavior.From there, we’ll move on to the building blocks of systems—entries, exits,and filters—and present specific examples of each, to better prepare the reader forthe more advanced concepts to be discussed later. Then we’ll cover trading strategyperformance, paying particular attention to certain problems associated with popular performance measures such as percent return, profit factor, and profit to drawdown. Specifically, we will illustrate how the same profit-to-drawdown statisticmay be good for one system and bad for another.Following our look at performance evaluation, we will explore the topic ofdiversification and explain why trading a portfolio of markets enhances the overallperformance of technical trading strategies. In most circumstances, trading a portfolio of markets produces better reward-to-risk characteristics than trading any single market on its own. We examine the benefits of trading a diversified portfolio ofmarkets, strategies, and parameters in our trading accounts.
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PART 1 Structural Foundations for Improving Technical Trading
We’ll close out the first part of the book with a discussion of the positives andnegatives of filtering entries and optimizing parameters. Optimization is an oftenhotly contested concept. Using real world results, we will attempt to quantify itsbenefits.
CHAPTER
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Introduction to Quantitative TradingHow Statistics Can Help Achieve Trading Success
TRADING STRATEGIES AND THE SCIENTIFIC METHODTrading is an unbelievably competitive business. Unlike other industries, there areno barriers to entry and the capital requirements are very