ics, 66, 67, 155, 165, 166–170stop loss exits, 236–243templates, 90–94Three in a Row, 222, 228–231volatility breakout, 63–65, 155, 160–164volume reversal strategy, 227, 232–233, 234–235See also Breakdown statistics; Relative StrengthIndex (RSI); Trading Strategy EvaluationPerformance statistics, 90–94. See alsoBreakdown Statistics; Trading StrategyEvaluationPhiladelphia Gold & Silver Index, 266Philip Morris, 134–135, 197, 202Pivot point high, 72Pivot point low, 71Popper, Karl, 75–76Positive correlation, 43Price oscillators, 66–69Moving Average Convergence/Divergence(MACD), 68–69, 170, 175–179Multiple Entry Oscillator System, 213–214,219–220Relative Strength Index (RSI), 66, 67, 165,170–174, 182similarities of, 182stochastics, 66, 67, 155, 165, 166–170Price patterns, 69Price volatility, 52–53, 318–319See also Market volatilityProfit factor, 78–80Profit taking, 242–243, 244Profit targets, 70Profit to drawdown, 80–82Profitability:distribution of profits, 101–102filtering and, 55, 117–123gross profit, 79–80
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341
Profitability (Cont.):net profit, 76–78, 87percent of profitable trades, 82–84profit factor, 78–80profit to drawdown, 80–82, 83of quantitative trading, 7trading signals and, 109–110(See also Filtering; Optimization)Profitable trading systems, 73Proprietary desks, 248, 263Prospect theory, 22, 25, 26–27, 30Pruitt, George, 219–222Pure arbitrage, in relative value trading, 248–249Put options:defined, 31payoff diagram, 259relative equivalence with call options, 31Pyramiding, 242–243, 244Quantitative trading strategies:creating new, 73–74, 321–328discretionary trading versus, 4–5entries, 55, 56–69exits, 55, 69–72, 236–243filters, 55, 72, 117–123, 181–182market timing, 294–299medium-term, 294–295modern traders, 11–13performance evaluation of. See Performanceevaluation of trading strategiespioneers of, 9–10Popper's theories and, 76profitability and, 7reasons for success of, 14–21recent explosion of, 10–11for relative value markets, 248–251, 267–283scientific method and, 3–5, 6–9, 76short-term, 295–303system trading, 6technical analysis versus, 7–9trend-following, 3, 15, 28–30, 56–65See also Performance evaluation of portfolios;Performance evaluation of tradingstrategies; Trading StrategiesRandom walk/efficient markets model, 14–15, 56,76, 124–126Range, 64, 65Rectangle bottom, 19Rectangle top, 19Reference value, 64Regime switching strategies, 118–121
Reid, Kenneth, 14–15Relative performance stock indices, 259–263, 297Relative Strength Index (RSI), 66, 67, 165,170–174, 182introduction, 10, 66in relative value trading, 272, 277, 280,281–283Relative value trading, 247–288channel breakouts, 267, 270–271developing strategies for, 266–267markets in, 251–266, 268moving averages versus, 277–278, 280, 283quantitative trading strategies in, 248–251,267–283See also Breakdown Statistics, relative value;Trading Strategy Evaluation, relative valueRenaissance Technology Corporation, 13Resistance, Saitta's support and resistance strategy,233, 236, 237–240Reward to risk, 82Risk:default, 254, 256expected returns and, 307in gambling, 99mean reversion and, 25, 27–29prospect theory and, 25, 26–27unbalanced, 134–135value of risky assets, 103Rosenberg, Barr, 14–15Royal Dutch NV, 264Russell 2000, relative performance index,259–262, 297Saitta's support and resistance strategy, 233–236Salomon Brothers' Bond Arbitrage Group, 31–32Salomon Smith Barney, 248, 258, 259, 300Scatterplots, 42–46Scholes, Myron, 31Schwager, Jack, 11–12, 85Schwartz, Robert, 11Schwert, William, 24Scientific method:Popper's theories and, 76quantitative trading and, 6–9trading strategies and, 3–5Second Order Breakout, 184–185, 190–191,192–195Securities and Exchange Commission (SEC), 63Sharpe, William, 84–85Sharpe ratios:calculating, 84–85distribution across parameter sets, 110–111
INDEX
342
Sharpe ratios (Cont.):diversification and, 104of filtered and nonfiltered channel breakoutstrategies, 245pyramiding and profit taking versions ofchannel breakout strategy, 243Shell Transportation and Trading PLC, 264Shiller, Robert, 24Short-term stock pair trading, 250Short-term strategies, 295–303day of month effects, 297–299day of week effects, 297–299exchange traded funds (EFTs), 295–297index funds, 295–297volatility index to trade S&P 500, 299–303Simple moving averages, 57Single stock pairs, in relative value markets,263–264Slippage, 139S&P 500, 289–304CBOE Volatility Index and, 299–303correlation with commodities, 45, 135–136,138medium-term strategies and, 294–295positive drift over time, 98relative performance index, 259–262, 297return distribution, 48volatility of, 50–53, 135–139Standard deviation, 39, 40–42, 46, 64, 65Standard error, 87Statistics. See Descriptive statistics; PerformancestatisticsStiglitz, Joseph, 63Stochastics, 66, 67, 182adjusted stochastic, 219, 223–226performance evaluation, 66, 67, 155, 165,166–170in relative value trading, 272, 278–279Stock index arbitrage, 249Stock markets:ADX filter with channel breakout, 119, 120,121optimization results in, 113, 114, 116relative performance of stock indices, 259–263testing, 129–130, 131trading the equity curve, 123–124Stock options, 31equity volatility and, 257–259hedge funds and, 291–292inefficiencies, 31–32pricing, 32See also Call options; Put options
Stocks:ADX filters and, 121, 122equity volatility, 257–259equity volatility, in relative value markets, 257–259interest rates and prices of, 292–294normalizing volatility of, 133–138popularity of, 289–292relationships with commodities, 45–46, 138,265–266single stock pairs, 263–264See also Breakdown Statistics, stocks; TradingStrategy Evaluation, stocksStop loss exits, 236–243Stop loss signals, 70Stops, 70Straddles, 257Substitution effect, 250, 264–265Support, Saitta's support and resistance strategy,233, 236, 237–240Swap spreads, 255, 256–257System trading. See Trading systemsTechnical analysis, quantitative trading versus, 7–9Technical Analysis of Stock Trends (Edwards andMagee), 5Technical Analysis of Stocks and Commodities(Kestner), 5, 181Technology stock bubble, 35–36Templates, performance evaluation, 90–94See also Breakdown Statistics; Trading StrategyEvaluationTexas Instruments, 221, 222Thaler, Richard, 24Theory, progression to trading rules, 7330-day VHF, 117Three in a Row, 222, 228–231Top-down relative value, in relative value trading,250TradeStation, 78–79, 87Trading Classic Chart Patterns (Bulowski), 21Trading rules, progression from theory to, 73Trading signals:for moving averages, 57–58, 69optimization, 109–110Trading strategies:price changes and, 55–56See also Performance evaluation of portfolios;Performance evaluation of trading strategies;Quantitative trading strategiesTrading Strategy Evaluation:futures, 90–93adjusted stochastic, 223
INDEX
343
Trading Strategy Evaluation, futures (Cont.):Alex Saitta's support and resistance strategy,237channel breakout, 141Divergence Index, 20380-day momentum, 15614-day RSI, 171Kestner's moving average system, 186MACD, 176MACD histogram retracement, 198Moving Average Confluence Method, 209moving average crossover, 146new volatility breakout strategy, 326Normalized Envelope Indicator (NEI), 215sample, 91Second Order Breakout, 192stochastics, 166Three in a Row, 22820-day momentum, 151volatility breakout, 161relative value:difference from 100-day moving average, 28480-day momentum, 27540 day entry/20 day exit channel breakout,27014-day Relative Strength Index, 281, 287stochastics, 27810-day/40-day dual moving averagecrossover, 273stocks:adjusted stochastic, 225Alex Saitta's support and resistance strategy,239, 240channel breakout, 143Divergence Index, 20580-day momentum, 15814-day RSI, 173Kestner's moving average system, 188MACD, 178MACD histogram retracement, 200Moving Average Confluence Method, 211moving average crossover, 148Normalized Envelope Indicator (NEI), 217Second Order Breakout, 194stochastics, 169Three in a Row, 23020-day momentum, 153volatility breakout, 163volume reversal strategy, 234Trading systems:defined, 6need for, 73–74
Trading systems (Cont.):optimization across, 111–112Trading the equity curve, 123–124Trailing exits, 70–71Trend-following techniques, 3, 15, 28–30, 56–65channel breakouts, 60–62frequency that markets trend, 124–125momentum, 62–63moving averages, 57–60problem of, 175, 180volatility breakouts, 63–65Treynor, Jack, 98Triangle bottom, 17Triangle top, 17Trout, Monroe, 11–12Trout Trading Management Company, 12Tudor Investment Corporation, 10Tversky, Amos, 22–23, 26–2720-day channels, 6020-day momentum, 150–15520-day moving average, 58–59200-day moving averages, 9Unilever NV, 263–264, 265Unilever PLC, 263–264, 265U.S. Treasury bills, 255U.S. Treasury bonds:ADX filters and, 121, 122Three in a Row, 227zero-coupon, 30–31University of Chicago, 102–103Value trading, 3Variance, 39, 40–42VHF (Vertical Horizontal Filter), 72ADX versus, 117, 11830-day, 117Vince, Ralph, 316Vince's optimal f, 316, 319VIX (CBOE Volatility Index), 257–259, 299–303Volatility. See Market volatilityVolatility breakouts, 63–65components of, 64performance evaluation, 155, 160–164rules, 65Volatility measure, 64Volatility multiplier, 64, 65Volume reversal strategy, 227, 232–233, 234–235Wang, Jiang, 15–21Warrants, 13Weighted moving averages, 57
INDEX
344
Wellington Partners, 13When Genius Failed (Lowenstein), 255Whipsaws, 59–60, 191Wilder, Welles, 10, 66Williams, Larry, 63, 69WorldCom, 254
Yahoo!, 134–135, 137Yield curve trading, in relative value markets, 250,251–253Zamansky, Leo, 115–117Zero-coupon bonds, 30–31
ABOUT
THE
AUTHOR
Lars Kestner is currently a founding partner of Sabre II LLC, a proprietary trading firm, where he focuses on developing new trading models as well as risk management. Previously he was Vice President of Equity Derivatives Trading atSalomon Smith Barney. He also worked at Brandywine Asset Management. He haswritten numerous articles for industry journals as well as one book. He received hisM.B.A. from Wharton.
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