une from theforces of fear and greed ourselves. Indeed, it is often difficult to fightthe crowd, even if common sense tells us that the trend is unsustainableor that the recent move in a market is based on hopes and dreamsrather than justified by the fundamentals. To further complicate things,these emotions can run markets into excesses for an extended periodof time.In order to keep emotions in check and to ensure that our investmentdecisions are based on rational decisions rather than hopes, dreams,greed, or fear, we use a variety of objective tools and indicators. Thesetools include specific rules and risk management strategies. System trading is but one example. In this type of investing, traders get their buy andsell signals from a set of clearly defined rules that are not subject to individual interpretation. Instead, the system tells the investor when to movein or out of the market. This chapter takes a closer look at system trading,and includes a few insightful examples.
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SYSTEM TRADING DEFINEDA trading system is a specific set of trading rules for entering and exiting atrade. Although a variety of approaches can be systematic or based on rules,the idea of a trading system is very rigid. Signals triggered by the system tellthe trader when to enter or exit a position. A trader who uses a system takesall trades generated by the rules and exits all trades when a signal is given.System Trader versus Discretionary Trader• A system trader follows a system that provides clear signals regarding when to enter or exit a trade.• A discretionary trader makes decisions as events unfold and basedon new information. The discretionary trader is more likely to makedecisions based on hunches, guesswork, and emotion.
A well-developed system is subject to rigorous backtesting. Thismeans taking historical market data and testing the rules for entry and exitover time. A solid system will work over long periods of time and can sometimes work across different market such as stocks, futures, or indexes. Importantly, if a system is developed using backtesting, but the traderintroduces some decision making into the process (i.e., when to take eachtrade), the actual results can vary significantly from the backtest results.When this happens, traders need to recognize that they are deviating fromsystem trading. Even if they deviate slightly by entering a trade midday instead of at the close, the chances are that results won’t be consistent withthe backtested results.At the same time, some flexibility can be built into a trading system bymaking changes to the indicators used in the system or by adding filtersaimed at reducing the number of trade entries for losing positions or earlyexits on profitable positions. A filter is an additional technical criterionthat can include parameters such as adding a second complementary indicator to trade entry or delaying an exit by waiting for a second close afteran alert. Collectively, these indicators and system components are definedas system parameters. If this sounds confusing, don’t worry—a detailedexample of system development is included later in the chapter.
WHY USE SYSTEMS?While there are many key advantages for traders who employ a systemsapproach, probably the most significant one is that it takes the guesswork
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and emotion out of the trading process. The emotional aspect of tradingcan be significantly reduced since systems are void of emotion and judgment. Unfortunately, the emotional tendency of a trader is to outguess thesystem, even when it’s producing profitable trades.If a trader can discipline himself to follow a system with rigor, emotions will not rule the decision-making process. Trading systems are designed simply to respond, not to feel. Developing a systematic perspectivetoward trading the markets is definitely a worthwhile endeavor and forthe most part far outweighs the discretionary approach.The discretionary trader typically makes a decision by reviewing various financial information sources like newspapers, television shows, andwebsites, and maybe even inspecting a few charts and indicators. Whenthe discretionary trader feels comfortable with the information, then hewill go ahead and actually put on the trade. However, a huge issue formany discretionary traders is that it’s very difficult to admit any mistakes.For example, if the discretionary trader has a bullish position in the market and the market declines, it can become an ego issue about being rightor wrong about the initial trade assessment. Without hard and fast rulessignaling an exit for the trade, the trader may remain in the market, ultimately risking the trading account.In sum, systems trading can alleviate the types of issues that constantly confront the discretionary trader. By applying a system-based trading approach to the markets, a trader can remove much of the emotionfrom the process. A good system clearly conveys when to enter and exitthe markets without the second-guessing that so often paralyzes the discretionary trader.
DOGS OF THE DOWThe “Dogs of the Dow” is an innovative example of a relatively straightforward and easy to understand trading system, which makes it agood first example. Michael O’Higgins was the first to outline this investment strategy his 1991 book, Beating the Dow (New York: HarperCollins). The theory in this approach is that the “dogs,” or those stockswith the lowest stock prices and highest yields, will eventually recoverand offer superior returns. In that respect, the strategy requires a bit ofcontrary thinking (i.e., the past losers will become the Dow’s futurewinners).The first step in implementing the Dogs of the Dow strategy is to takethe 30 stocks within the Dow Jones Industrial Average (see Chapter 1) andrank them by dividend yield. The 10 stocks with the highest dividendyields are the Dogs of the Dow. The portfolio is rebalanced at the start of
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every year. So if a stock is a dog one year but is not among the top 10 withthe highest dividend yield the next year, it is removed from the portfolio.
Computing the Dividend YieldA dividend represents a company’s proﬁts that are passed along to theshareholders. Companies generally pay dividends quarterly. For instance,a company might pay a $0.20 dividend quarterly. The annual dividend istherefore $0.80. The dividend yield is computed as the current dividenddivided by the share price. If a shares trade for $25 and the company paysand $0.80 dividend, the yield equals $0.80 divided by 25, which comes to3.2 percent.
According to O’Higgins, the Dogs of the Dow portfolio produced average annual returns of 17.9 percent from 1973 to 1989, compared to an 11.1percent gain in the Dow itself. Throughout the 1990s, the results of theDogs of the Dow approach were mixed. From 1996 through 1999, the 10dogs underperformed the Dow Jones Industrial Average. However, from1999 through 2003 the performance improved. According to the Dogs ofthe Dow web site (www.dogsofthedow.com):During the difficult bear market years of 2000–2002, the Dogs of theDow were up 6.4% in 2000, down 4.9% in 2001, and down 8.9% in2002, and that was enough to significantly outperform the Dow,S&P 500, and NASDAQ. In 2003, the high dividend stocks of theDogs of the Dow gained 28.7% and made new, all-time highs despitethe massive bear market of 2000–2002!In 2004, the Dogs of the Dow gained just 0.5 percent, compared to a4.4 percent gain in the Dow Jones Industrial Average. In 2005 (through December 21), the Dogs underperformed the market miserably. While the industrial average sat near the unchanged level, the Dogs of the Dow hadsuffered an 8.5 percent decline (excluding dividends). The strategy performed much better than the market during 2000–2003, but the results reversed in 2004–2005. Nevertheless, the long-term track record still stands.The Dogs of the Dow strategy is an example of a system because ithas clear entry and exit rules that leave nothing to the imagination. Eachyear, the portfolio is rebalanced using a set of rules. The exit strategy alsofollows guidelines. The strategy also has a certain logic to it—in otherwords, to profit from the fact that shares of dominant companies with
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high dividend yields tend to outperform the market over the long term. Inaddition, the strategy has been backtested using historical data. Therefore, it has all of the characteristics of a good trading system.The MUTReaders can track and trade the Dogs using the individual stocks or theDogs of the Dow Index ($MUT). The index, which has the easy-to-rememberticker symbol MUT, has options listed on the CBOE. Like most other indexes, these options settle for cash European-style, which means that exercise and assignment can only take place at expiration. Traders can usethe MUT options to bet on a decline in the index with bearish spreads; orthese options can be used to establish bullish spreads if traders expectthe Dogs to run higher.Note: It is important for the trader to understand the impact of dividendson both calls and puts when formulating an option strategy that uses anunderlying security with a high dividend yield.
As with other systems, the rules and guidelines for the system must befollowed or the results might substantially deviate from the system’s historical returns. As an example, what if the investor decides not to invest inone of the Dogs? Table 9.1 shows the possible candidates for the 2006Dogs as of late December. General Motors (GM) is at the top of the listwith a dividend yield of more than 10 percent. However, the auto industryTABLE 9.1 Likely 2006 Dogs (as of 12/21/2005)Likely2006 Dog
Symbol
Dividend Yield(12/21/05)
General Motors
GM
10.50%
AT&T
T
5.44%
Verizon
VZ
5.29%
Merck
MRK
4.76%
Altria
MO
4.19%
Pﬁzer
PFE
3.99%
Citigroup
C
3.57%
DuPont
DD
3.46%
JP Morgan Chase
JPM
3.41%
General Electric
GE
2.83%
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is in trouble and GM has plummeted more than 50 percent in 2005. So perhaps that stock is better left out.If the investor chooses to leave General Motors out of the Dogs of theDow in 2006, he is violating the rules of the system. His decision is basedon emotion rather than rules. It is possible that the investor’s expectationsare correct and shares of General Motors have another terrible year in2006, but a true system trader does not try to second-guess the system. Although the results for the year are not yet available, in this example theportfolio would be rebalanced to include the referenced top 10 stockswith the highest dividend yields. This action should occur regardless ofhow poor the company’s fundamentals may seem at the time.
THE VOLEX SYSTEMWhile the Dogs of the Dow approach is an example of a trading system, itis also a buy-and-hold strategy that is suitable for investors with a longterm time horizon. It would be suitable, for instance, for a retirementfund, college fund, or some other long-term financial goal that is manyyears away. While the strategy works over time, there will be down yearsand investors must be willing to accept that risk. For instance, the mostrecent year, 2005, was a miserable year for the Dogs. We provide the strategy here because it is based on an index (this book’s focus) and it provides a nice basic example of a trading system.Most of the systems we develop are designed for short-term tradersand options strategists. The Volex system is such an example. It was originally developed by Bill Cruz and Charlie Wright, and we use it with a slighttwist to trade the S&P 500 Index using the SPDRs. This system uses theVolex indicator and changes in volatility to forecast change in price byconfirming trends or changes in direction. The indicator typically displayslower levels of volatility when the current trend is intact, while higher levels of volatility will frequently be encountered when changes in the trendoccur. The first step to understanding the Volex system is to understandthe Volex indicator. This requires a look at a measure of volatility knownas average true range, which is also discussed in more detail in Chapter11 and in Appendix B.
Average True RangeThe average true range (ATR) was originally developed by the legendarytrader J. Welles Wilder and represents a measure of past volatility. Volatilestocks tend to move more aggressively through a wide price range and
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will have higher ATRs, while stocks or markets with little movement andquiet trading will have lower ATRs.The ATR does not provide an indication of direction or duration, but itdoes identify the degree of price movement or volatility. Higher ATR values often occur at market bottoms and typically follow a panic sell-off.Low ATR values are often found during extended sideways periods, suchas those found at tops and after consolidation periods.In order to compute the ATR, one must first compute the true range(TR) of price movement. The formula for the true range includes threecalculations: (1) the current day’s high minus the current day’s low; (2) thedifference between previous close and current high; and (3) the differencebetween the previous close and the current low. The true range is thegreatest value derived from these calculations. Figure 9.1 provides a visualrepresentation of these ranges.The true range is computed as the difference between the high andlow when the day’s trading range is large.• In the case of a large gap down: When the previous close isgreater than the current day’s high, the TR is the difference betweenthe previous day’s close and the current day’s high.• In the case of a big gap higher: When the previous close islower than the current day’s low, the TR is computed as the difference between the previous day’s close and the low of the current day.
FIGURE 9.1 True Range Visual
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The ATR AdvantageThe ATR is derived from past prices. Developed by Welles Wilder and discussed in his book, New Concepts in Technical Trading Systems (McLeansville, NC: Trend Research, 1978), the ATR is used to measure daily priceswings. It was ﬁrst used in the commodities market, but can also be applied to stocks and indexes. Wilder developed the ATR to help account fordays when prices gapped higher or lower. A gap occurs when a stock ormarket opens the trading session signiﬁcantly higher or lower than theprevious day’s closing price. It is known as a gap because the suddenmove results in an empty space, or gap, on the price chart. Most measuresof historical volatility consider only the closing prices for a stock or indexand fail to capture the volatility caused by sharp gaps. The ATR, however,considers the close, high, and low prices of the day.
The ATR is simply the average of the true ranges over a period of days(generally 14). As each day of new data is added, the last is dropped. Oncethe true range has been calculated for each interval, the true ranges for allintervals in the user-defined periods (x) can then be averaged.The ATR calculation using the default value of 14 is the sum of 14 TRvalues divided by 14. Or more generically:ATR = TR1 + TR2 + TR3 + . . . + TRx / xThe ATR indicator is available on most charting software today. Figure 9.2 shows the S&P 500 Index with the ATR indicator along the bottom
FIGURE 9.2 S&P 500 Index with ATR Indicator (Source: www.ProﬁtSource.com)
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of the chart. When it rises, it indicates that the volatility of the index is increasing. Notice that as the bars get wider, the ATR tends to rise. However, during periods of quiet trading the ATR will fall.
THE VOLEX SYSTEM ENTRYThe Volex is constructed by creating bands around the ATR. It multipliesthe ATR by a constant value to construct a portion of the setting. The ATRmultiple will dictate and control the spread between the two lines. A common multiple is 1.3. The following formulas are used to compute thebands for the Volex indicator:Upper band value = Current day high + (ATR  ATR multiple)Lower band value = Current day low – (ATR  ATR multiple)To create the upper Volex band, the current day high is used as thebase value and the ATR component is added to it. To create the lowerVolex band, the current day low is used as the base value and the ATRcomponent is subtracted from it. Keep in mind that when the number ofperiods used in the indicator is increased, the Volex lines will besmoothed. Decreasing the number of periods will make the lines more responsive to current prices. Figure 9.3 shows daily values for the S&P 500Index with Volex bands; the ATR is plotted along the bottom.When applying the Volex system to a particular stock or index fortrading, it is paramount the trader understands the entry and exit rules.
FIGURE 9.3 Volex and ATR on S&P 500 Index (Source: www.ProﬁtSource.com)
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The Volex system seeks to go long upon price movement that is beyondthe average range and seeks to go short upon price movement that is below the average range. Assuming Volex indicator settings of nine dayswith an ATR multiple of 1.3, new trade signals are generated when pricepenetrates one of the bands.
Entry RulesThree rules govern entry into a trading position using the Volex system:1. The Volex system calculates long and short values from the ATR. If
the security price or index level penetrates either of the two Volexbands, a position is established.2. A break to the upside initiates a long position in SPY shares (or callson $SPX or SPY). A break of the lower band initiates a short sale onthe SPY (or long puts on $SPX or SPY).3. If a trade is not established, then the system resets itself with newlong and short triggers calculated.Figure 9.4 shows an entry signal using the Volex system. The signaloccurred in October 2004 when the S&P 500 broke above the upper Volexband.Note: This is a chart of the SPY. However, we prefer to use the S&P500 Index to get entry and exit signals for the Volex system. Once the signal is generated, the trade is initiated with SPY shares.
FIGURE 9.4 Volex Entry Signal (Source: www.ProﬁtSource.com)
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THE POINT AND FIGURE EXITIn the traditional Volex system, trades are exited either long or short whenthe Volex System triggers another signal in the opposite direction. Sowhen a long position is established, price penetration of the lower Volexband signals the trader to close the position. However, we have a twist onthe original Volex system using point and figure (PnF) charting with theobjective of trading the S&P 500 Index ($SPX) more profitably.Point and figure charts are different from the other types of chartsfrequently encountered. They reflect price movement only—there is notime interval or volume distinction on them. PnF charts include a seriesof X columns and O columns, with the X columns indicating upwardprice movement and the O columns indicating downward price movement (see Figure 9.5). Each X and O is referred to as a “box” with a newX or O column created when a price reversal has occurred. The sensitivity of the chart is adjusted by changing the box size and/or reversalcriteria.The basic concept behind PnF is one of supply and demand. An uptrend indicated by a rising column of Xs tells the trader that demand hasexceeded supply. A falling column of Os indicates a downtrend, whichtells the trader that supply has overcome demand. An interruption ofthese vertical columns by short alternating columns of Xs and Os indicates that supply and demand are fighting each other for supremacy. Thismay indicate a potential change of trend or simply be a continuation pattern (trend and countertrend).
FIGURE 9.5 Point and Figure Three-Box Reversal (Source: www.ProﬁtSource.com)
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We use the three-box reversal system. This means that the marketmust move three points in the opposite direction before changing thechart plot from Xs to Os, and vice versa. Keeping the original ATR andmultiplier settings the same, we will now incorporate a PnF filter into theexit strategy. Figure 9.5 shows an example of reversal on the PnF chart.Traders interested in learning more about PnF charts might want to readthe book Three-Point Reversal Method of Point and Figure by Michael L.Burke (New York: Chartcraft, third edition 1993).Volex System SummaryThe Volex system provides entry and exit signals for the S&P 500 Index($SPX). When a buy signal is triggered, a position is taken in SPY shares.When the sell signal is triggered, shares are sold. The system can also provide short trading signals.• The long entry signal is triggered when the S&P 500 breaks the upperVolex band. A short signal is triggered when it breaks the lower band.• The exit is based on the PnF chart. When the chart reverses down to acolumn of Os using the three-box reversal method, the long positionis closed. A short position is closed when the PnF chart shifts from acolumn of Os to a column of Xs.
Exit RulesWhen a long position has been established and there is a break of thelower Volex band accompanied by a three-box PnF reversal (a new column of Os initiated), we close the long position in SPY shares (or calls on$SPX or SPY). When a short position was established and there is a penetration of the upper Volex band accompanied by a three-box PnF reversal(a new column of Xs initiated), we close the short position in SPY (orclose the long puts on $SPX or SPY).Table 9.2 shows the results from the performance of the PnF Volexsystem after multiple tests using the purchase of spider shares. Theback-test period is from 1994 to 2004; the results are based on $50 pertrade to include slippage and commission. Winning trades slightly outnumber the losers by 286 to 211. The average winning trade producesprofits of more than $2,300, compared to an average loss of $960. This iswhat we like to see in our trading systems—losses cut short and biggergains from our winners. The average win-to-loss ratio is a very importantstatistic.
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TABLE 9.2 Volex Results of the Last 10 Years Using the S&P500 IndexPoint and Figure Volex System
Total Net Proﬁt
$475,900.00
Gross Proﬁt
$685,460.00
Gross Loss
($209,560.00)
Proﬁt Factor
3.27
Total Number of TradesPercent Proﬁtable
49757.55%
Winning Trades
286
Losing Trades
211
Even Trades
0
Average Trade Net Proﬁt
$957.55
Average Winning Trade
$2,396.71
Average Losing Trade
($993.18)
Ratio Average Winning: Average Losing
2.41
Largest Winning Trade
$20,204.00
Largest Losing Trade
($4,204.00)
Here is the Volex with $50 per trade to include for slippage andcommissions. Results on the last 10 years using the S&P 500 Index.
SYSTEM DEVELOPMENTWhen developing a system like the Volex System, there are some important factors to keep firmly in mind.
Key ComponentsIt is paramount that any system addresses three key pieces of information:1. A market entry signal that provides clear rules about when and where
the trader should get into the market.2. A market exit signal that tells the trader when to exit the market witha profit.3. A market exit signal that tells the trader at what point to exit the market with a loss.
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Once these three decision points are defined, there are some otherfactors that should be considered when selecting or developing a tradingsystem. Traders should decide just what market and particular time framethey would be trading. They should also select a core idea as the drivingtheme when designing or selecting a system (i.e., capturing a momentummove). This idea needs to be something the trader not only firmly believesin but also has proven performance that instills confidence due to thebacktesting of historical data.The trader also needs to be comfortable with the system’s predictiveperformance as well as its risk/reward ratio. Once the system has been puttogether, it is always a good idea to see how the performance can be improved. A systems trader will thoroughly test the system before actuallytrading the signals. When evaluating a system the trader needs to know justhow well the system can be expected to perform and what the risks are.One of the basic requirements of a usable trading system is that itneeds to be relatively simple to interpret and easy to execute once tradingsignals are generated. Again, all systems must provide a clear market entry signal as well as signals for market exit that include a profitable exitand an exit for a loss. Before any trading system is deemed effective andusable for the long term, it is paramount that the system addresses thesethree key building blocks.
System ResultsNow that we know the key features and requirements of a trading system,we need to determine how best to evaluate it, regardless of whether thetrader purchases the system or develops it on his or her own. This bringsus to system testing, determining how the approach can stand up to therigors of real-world trading. Key concepts to understand and factors tolook for in the testing process include maximum drawdown, averagewinning trade, average losing trade, and percent profitable.• Maximum drawdown: The maximum drawdown statistic providesthe system developer an approximation of just how much capital willbe needed to trade this approach. It is the sum of most consecutivelosers encountered. Most system developers and traders say it is agood rule of thumb to double the maximum drawdown figure to determine the amount of capital needed to trade a particular system.• Average winning trade: The average winning trade is the dollaramount of all the winning trades divided by the number of winningtrades.• Average losing trade: The average losing trade is the total numberof dollars lost divided by the number of losing trades. Using the average
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winning and losing trades, we can come up with an average win-toloss ratio by dividing the average dollar amount of the winners by theaverage dollar amount of the losers. Of course, the higher the betterfor this statistic, but it should be at least a two-to-one ratio.• Percent profitable: Finally, you want to evaluate the percentageof profitable trades to determine if the system is worthy of trading.This is where the system developer has to judge whether the trading system actually fits his trading style. Some people want a veryhigh probability system (higher percent profitable) and can handlesmaller win-to-loss ratios, whereas other traders can handle a lowerprobability of win figure, provided the win-to-loss ratio is largeenough.Only by going through this type of trading system analysis can thesystem trader gain a good sense of how well the approach being tested isexpected to perform and the associated risks.
SYSTEM DEVELOPMENT EXAMPLEIn the past, either large institutions or traders with very deep pockets developed systems like Tom Gentile’s S&P 500 Index Volex system. Today, avariety of software packages are available to smaller investors that allowthem to backtest and implement trading systems. In short, it is not the expensive proposition it once was. In addition, backtesting used to requireadvanced computer language knowledge and a large number of cumbersome calculations. Today, the software makes the process much easier.Let’s take a look at the development of a trading system using ProfitSource software and two technical indicators. The following example waspresented and discussed in a series of Optionetics articles for the purposeof walking through the process of system development. Various speedsand combinations for rate of change (ROC) and the average directionalindex (ADX) indicators were used to develop the system. Although profitable over a variety of market conditions, it is not a system currentlyused—the trader confidence level in the system was affected by an illogical aspect of the trade exit. However, the goal here was to teach the stepsneeded to create and evaluate a system, so the focus is on process ratherthan on reviewing the indicators themselves.
Rate of Change IndicatorThe ROC is a basic momentum indicator that measures the rate of ascentand descent for price. Trade alerts and signals can be generated using a
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chart that combines ROC with a simple moving average (SMA) line on theindicator. These two indicators—ROC and an SMA on ROC—were used tocreate a base trading system. The ADX indicator measures the “trendiness” of price and was added to the system as a filter—an additional requirement that must be met for a signal to be generated. Please visit theAppendix B for more information regarding the ROC and ADX, as well asother commonly used technical indicators