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where the market would react to predicted resistance. This ability to predict an event and then to monitor it as it occurs is very powerful.Figure 7.7 presents another example. The same principle is in evidence here but it is shown in much faster time frames. The focus is thedaily, the higher time frame is the weekly, and the lower time frame isthe hourly.The situation is very similar to the previous example although thetime frames are different. Support is established on the Weekly Chart,and in the same area on the daily chart. On the 60-minute chart we seesupport from the daily area represented by the large rectangle as wellas support from the 60-minute chart. This coordination of multiperiodsupport gives the trader a clear indication of a good place to buy.Note that in these examples the technique works regardless of thetime frames used.Another example, Figure 7.8, uses yearly bars. Yes, you read correctly, yearly bars! These longer time frames can be very valuable. Imagine how effective your trading could become if you knew that the yearlyhigh was in place!In Figure 7.4 the yearly time frame shows support from the live dotand the Drummond Line. This support area is carried over to the quarterly chart and shown as a rectangle. Support in that area on the quarterly chart is similarly carried over to the monthly chart and shown asa rectangle. Support is likely to be strong and hold when it is backed upby support from higher time periods.This multitime period of analysis is very helpful. When combinedwith other elements of Geometry or other technical analysis tools,traders develop an understanding of how support and resistance reinforce
FIGURE 7.7 Dow Jones: Weekly-daily-60 minute. Created with Omega ResearchProSuite 2000i 1999.
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FIGURE 7.8 Dow Jones: Yearly-quarterly-monthly. Created with Omega ResearchProSuite 2000i 1999.
each other and weave together into a coordinated approach to marketanalysis that helps them approach the market with confidence.The question arises: how many time frames should a trader try tomonitor? If three time frames are better than one, then shouldn't twelvetime frames be four times better still?'In theory, there are an infinite number of different time frames, beginning with one-tick bars, moving from there up to one-minute bars,and BO on up to infinity. We can't possibly monitor all of these. Fortunately, we don't have to.Bear in mind that if two time frames are very close together, thenthey w i l l be nearly identical. Although traders may not know whichtime period is exactly optimal, when they are very close together thenthe information one gets from each time period will be very similar, andhence of less value.Should one use the 60 tick chart? Would not a 65 tick chart be better? Why not a 67 lick? What if everyone used the 60 tick, then maybe adifferent time period chart would be better?' There is no end to the speculation, and all of these questions are valid. However, one thing thatcan be said for certain, is that it is helpful to have time period chartsseparated by a significant amount of time as opposed to being very closeto one another. The useful information comes from the major differences and major similarities in support and: resistance as the energy ofdifferent time frames is mapped.The factor-of-five rule helps determine which time frames to selectfor this type of analysis. This rule states that the first higher time frameshould be roughly five times as long as the focus time frame. The second
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higher time frame should be five times as long as the first higher timeframe, and so on. Similarly the first lower time frame would ideally befive times lower than the focus time frame, and so forth.This is a rule-of-thumb: there is nothing "magical" about the ratioof five to one. But if the ratio is nearly 1:1, the trader will see onlythe fine-tuning of a single energy wave; if the ratio is 10:1 or 25:1. thetrader runs the risk of missing important information.The intraday minimum can be a factor of two: and when looking atlong lime frames on the yearly chart, we often look at the 2.5-year chartto establish context.Here is a representative set of time frames that have worked wellempirically over time:5 minute30 minuteOne hourDailyWeeklyMonthly
QuarterlyYearlyTwo-and-a-half yearFive yearTen year
Many contemporary charting packages permit the trader to construct price bars based on ticks rather than the amount of time thathas passed. Each bar is formed after a certain numher of ticks or mini m u m price changes occur. These tick bars are very helpful as theytend to smooth out periods of slow market activity and result incharts that clearly show the full range of market energy playing out,and can account for the tick volume geometrically. A 60-tick chart inT-Bunds is usually about equivalent to a conventional fifteen-minutechart: a 360-tick chart in T-Bonds is usually equivalent to about anhourly chart. Tick charts are particularly helpful in revealing the underlying market structure in markets that have periods of very thintrading, such as during the overnight hours. A ten-minute chartmight show many periods with little or no activity, where as a 100tick chart would collect all of that activity into a bar that would befilled with all of the actual market activity, independent of the timeelapsedIf you have charting software that permits this kind of data manipulation, by a l l means experimental with it and see if you find it of valuefor your trading style. To get an idea of the number of ticks to use, setup a one-tick bar chart and count the number of ticks in an hour. Bondsmight have 360 ticks per hour on average, and Soybean Oil 60 per hour,and so on.
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CONCLUSIONTraders who analyze support and resistance will have much greater success if they coordinate these support and resistance levels on severaltime periods. Daily resistance sold in the area of weekly and/or monthlyresistance has up to three times the likelihood of being strong and holding than does daily resistance taken in places where it exists by itself.The determination of whether or not resistance is strong or weak can beseen at the earliest by monitoring the trade on a time frame that islower than the time frame in which the trade is taken, A trader who understands the context of a market will always be better off than onewho trades by looking only at a single time frame. Drummond Geometryoffers a comprehensive methodology of establishing support and resistance areas in multiple time frames, and then coordinating their locations to determine their strength or weakness.
8INTRODUCTION TO MECHANICALTRADING SYSTEMS
The foundation of all mechanical trading systems is technical analysis.The basic tenet of technical analysis is that history will somewhat repeat itself. System traders and market technicians will always be tiedtogether in this one belief.Many people reject the notion that market activity is repeatable or ordered, because they feel whatever pattern occurred before is random orwithout precedent. They believe present trading conditions are too unlikeanything that happened in the past to make any type of valid comparison.The market has no memory and every situation is unique. There is a fallacy in this way of thinking. Every day and market situation is unique,but there are common patterns which may he generalized, just as everyperson is unique, but generalities exist for all humans. Everyone may nothave the same likes and dislikes, but everyone has likes and dislikes.(Robert Rolella, The Elements of Successful Trading New York Institute ofFinance 1992)A mechanical trading system is a mathematically defined algorithm(step-by-step instructions) that is designed to help the user make objective trading decisions. These instructions are based on historically reoccurring events. With the use of a trading system, a small amount ofmoney, and a telephone, a person can open an account and start tradingcommodities and/or stocks. How successful that person is depends onseveral factors:• Amount of starting capital.• The person's trading psychology.• Validity and robustness of the trading system.
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Most, beginning commodity traders fail. This failure rate can be attributed to the amount of money that a trader begins with. All systems.even good ones, can go through draw-down periods. If a beginningtrader (1) starts with a small amount of money and right off the bat hasa significant draw down, that trader will usually quit. Unfortunately,most traders quit right before a system turns around. If another trader(2l has more starting capital and experiences the same draw down, thatperson is more likely to continue trading.
Starting capital ($)
Drawdown ($)Drawdown (% of starting capital)Effect
Trader A5,0005,000
Trader B10,0005,000
100
50
Quits
Continues
A person's trading psychology can make or break a trading plan.One advantage of a trading system is the elimination of human emotion.The computer makes all of the decisions and the trader is along for theride. When a trader overrides a system trade, he loses that advantage.How many traders will follow a system trade after it has issued fivelosers. To reap the benefits of system trading, all system traders shouldtake the sixth trade.The most important thing to a system trader is the validity of thesystem that he has built his trading plan around. If the system isgarbage, then the whole trading plan will fail. The rest of this book isdesigned to guide the reader through the pitfalls and obstacles presented by trading systems. We can't control how much money you startwith, nor can we change your psychology, but we can help you designand/or buy decent trading systems that may have a good chance of beingprofitable in the future.Example of a mechanical trading system: Buy if the 9-day movingaverage crosses above the 13-day moving average. Sell if the 9-day moving average crosses below the 13-day moving average. If the buy/sellorder is filled then place a $1500 protective stop. If the open profit exceeds $2000 then use a $500 trailing stop. This is a precisely defined algorithm. If two different traders were to trade this system, their overallresults would and should be similar.Example of a trading tool: When the stochastic enters the overbought region and begins to hook down and a head and shoulder pattern comes to an end then short the market on the open. Place aprotective stop at the nearest support level. This is a loosely defined algorithm; there are no exact parameters. Unlike the mechanical trading
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system, if two traders were to follow this approach, their overall resultwould probably be quite different. Many traders don't believe the markets can be traded with a mechanical approach and therefore use toolsto help in their trading decisions. This type of trader feels that the markets are so complex, that a simple mathematical formula cannot interpret all of the parameters and nuances that are involved with marketmovement.Mechanical trading systems and technical analysis have been provento make money in the markets. Not all systems have made money, but afew have and this has given rise to a multimiltion dollar industry. Aswith any type of "get rich if you follow my instructions" scheme, this industry has developed a somewhat bad reputation. There are many selfappointed experts and gurus selling $3000 systems to people who havenever heard of technical analysis. You can turn your television on late atnight and for $95 you can learn how to become a successful trader. Youdon't need experience, a lot of money (other than the $95). time nor an education in technical analysis. Who would believe this? A lot of peoplewould, including lawyers, doctors, scientists, financial engineers, CEOs,and maybe even yourself. The Commodity Futures Trade Commission(CFTC) is trying to crack down on these rainbow merchants (we have attached this label to system vendors who paint trading as a pretty and colorful picture), by requiring them to register as informational commoditytrading advisors (CTA). If system vendors are registered, they have to becareful and conscientious of the literature they distribute. Not all systemvendors are snake oil salesmen, we have dealt with some of the most responsible, intelligent, and conscientious people in the industry. Some ofthese vendors even trade their own money and/or have clients that havepositive real time results using their systems.
WHY USE A TRADING SYSTEM?
There are several different reasons why a trader should use a tradingsystem:• Continuous and simultaneous multimarket analysis.• Elimination of human emotions.• Back teat and verification capabilities.Mechanical system traders believe that the trending nature of themarkets can he understood through the use of mathematical formulas.With the correct filtration, the noise (congestion) can be removedfrom the music (trend). We believe that the markets, be it soy beans or
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currencies, are continuously in this state of flux; trending or congesting. Accepting this premise, we have discovered that a single system canprofitably trade many markets. This is a tremendous benefit becausetraders can trade all kinds of different markets without having to fullyunderstand the nuances of all of the individual markets. On any givenday. a system trader can be trading 50 markets simultaneously withgreat ease. Through the use of a system, a trader can also take advantage of the non-emotion factor: With the computer making all of the decisions, there are no human emotions involved. Human traders canwake up on the wrong side of the bed or he suffering from the flu andthis can have a tremendous impact on their trading decisions. Tradingsystems don't care how we humans are feeling, they continually monitorthe markets and make their objective trading decisions.Mechanical trading systems (MTS) can be verified and analyzedwith accuracy. With the use of data and a computer (or pencil, note pad,and calculator), this type of system can be back tested over decades ofhistorical data. The back testing and verification attributes of MTS areprobably the main reason that this approach is so popular. Through theuse of back testing, traders can get a sense of a trading plan's viability.Unfortunately in a lot of cases, a historical track record of a MTS canbe misleading. Some system vendors over optimize a system's parameters to look favorably when tested on historical data. (This is known ascurve fitting and will be described in greater detail in the next fewpages.) Historical back testing has the benefit of hindsight and must belooked on with a certain level of skepticism. On a positive note, a verified walk forward test of a MTS can be highly enlightening. A walk forward analysis is a test on market data that was not available when thesystem's parameters were derived. This type of analysis is by far themost revealing when evaluating a system's performance. The longer thewalk forward test, the better.Of monies under management of commodity trading advisors, 80%was traded by systems. Commodity Trading Advisors (CTA) use systemsdue to their ease of use, non-emotion factor, and their ability to be usedas a foundation for an entire trading platform. The trading system is buta mere beginning, the tip of an iceberg, for a serious money manager.With the use of a mechanical trading plan, money management and portfolio analysis, today's CTAs systematically manage billions of dollars.Since everything is mathematically defined, a CTA can demonstrate ahypothetical track record based on the different needs of his clients. Indoing so, he can customize a specific trading plan. Without a mechanicalapproach to the market, he could not do this; he could not look back overdecades of data and accurately demonstrate his subjective analysis.MTS can give somebody, who has no idea of the soybean market, theability to trade this market and at the same time trade many differentmarkets.
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THROW THOSE ADS AWAYMTS sounds like the greatest thing since sliced bread. Why doesn'teverybody buy a system and make a lot of money and then retire? Unfortunately, it's not that easy. The only thing a valid system can give itsUser is a slight technical edge. This edge will hopefully make a littlemoney over the long run. Many seasoned traders have commented thatthis is the hardest business in which to make an easy buck. However, forthe educated trader there does exist a Holy Grail. The Holy Grail is theknowledge that a Holy Grail does not exist. This is why all potentialsystem buyers should throw away any ad, sales literature, and any othertype of propaganda that looks to good to be true. And all system developers should do the same if they devise a trading system that looks togood to be true. Figure 8.1 is fictitious but it is similar in content tomany ads that can be found in different periodicals and/or on the WorldWide Web.The equity curve shown in Figure 8.1 looks too good to be true andit is. This equity curve was created by a mechanical system that wascurve fitted to the nth degree. The track record covers sixteen differentmarkets over an eleven-year test period. A lot of people would look at
FIGURE 8.1system.
Typical Holy Grail ad. Sample track record of an overly curve-fitted
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the length of time and the different markets involved with this test andsay that there is no way a person could curve fit that much data. Hereinlies the trap. With the computer power and ample data that is availabletoday, any type of equity curve can be generated. Figure 8.1 was builtfrom 1983 through 1993 data. We only used this amount of historicaldata so that we could reserve some data for a suitable out of sampletest. Figure 8.2 shows how the exact same system performed in a walkforward test from January 1, 1994, through August of 1999.The unknowing system purchaser was expecting approximately$82.000 in profit a year and $25,970 in maximum draw down, when infact he only averaged $6,245 a year and suffered through a maximumdraw down of $62.808. That is a decrease of 76%. in profit and an increase of 151% in maximum draw down.Is the system vendor that shows this type of hypothetical performance lying? No, he is not. IB he misleading the public? Yes, because heshould know better. The vendor of this type of system knows that forthis type of performance to continue, history must repeat itself almostexactly.
FIGURE 8.2 Sample track record of a walk forward test on the same system.
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SHOULD I BUY A TRADING SYSTEM?We have painted a gloomy picture of the MTS industry. However, we believe that good research can be purchased and successfully used at theretail level. System buyers must do their homework before purchasing anew system or they will be victimized. As a potential system purchaser,you must understand that hypothetical track records only give the bestcase scenario. Hypothetical or simulated performance results have certain inherent limitations, Unlike actual performance records, simulated results do not represent actual trading. Also, since the trades havenot actually been executed, the results may have under-or-over compensated for the impact, if any. of certain market factors, such as lack ofliquidity. Simulated trading programs in general are also subject to thefact that they are designed with the benefit of hindsight. As a rule ofthumb, you should expect only one half the total profit and twice themaximum draw down of a hypothetical track record. You should onlyuse this rule of thumb, if you are confident that the system being backtested has robust parameters (parameters that weren't curve fitted tohistorical data—if you don't understand what robustness means, don'tworry we will discuss it in full detail later). Unfortunately, the only wayto determine a system's robustness is to understand the logic and mathematics behind the system, and to do that you usually have to buy it. Insome cases, with black boxes, you never see the logic, so beware. If youwant to purchase a trading system and don't want to get burned, propose the following questions to the system vendor. If you can't answeryes to most of the questions, then move onto another system.Pre-System Purchase Questions:1. Does the hypothetical historic record look good over a ten-yeartest period?You would be amazed how often a system vendor shows performance of a system for less time than this. They use the excusethat the markets have evolved and that data ten years ago has norelevance to today's markets. Many times, if a certain market istrending like the recent moves in the S&P 500, vendors will onlyshow performance over the most recent time period2. Does the hypothetical historic record look realistic? Average annual returns less than 150% on 3*margin. (Margin is the amountof deposit necessary to trade a certain market.)Systems that generate consistent performance greater thanthis are usually overly optimized and are doomed to fail in thefuture. Let's get real! If a system performed this well, then therewould be no markets.
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3. If it is a multiple market system, are the parameters the same orsimilar for all markets?Another indication of over optimization and curve fitting. Ifparameter A is 26 for the Japanese Yen and 102 for the SwissFranc and 56 for the Deutsche Mark, then there is a goodchance that the parameters were curve fit. Parameters shouldbe similar for different markets especially if the markets are insimilar sectors.4. Is there a real time track record for a minimum of 18 months? Ifso, is it respectable?The only true test is the test of time. If a system performswell after it is released to the public (or after the vendor hasstopped tweaking the parameters), it has demonstrated the ability to trade on unknown data. The system doesn't have to duplicate historical performance to be considered good. If it performshalf as good as the historical performance, then it probably has afair chance of future success.5. Does the system seem logically sound and not overly complex?Systems should be simple and based on price movement. 1have never seen verified systems that based trades off of astrology, numerology, day of month, astronomy, and so on. Overlycomplex approaches usually get bogged down and confused.6. Does the system vendor seem more like a technician than asalesman?After initially contacting a system vendor, does he call frequently pressuring you to buy his system? Does he boast of hissystem's performance or does be let his real time track recordspeak for itself?7. Has the system been tested by a third party?Third party verification is the beat objective analysis thatyou will receive. A person other than the vendor or paid by thevendor that can share his experience with either real time tracking or trading of the system can solidify your buying decision.
MYTHS AND FACTS CONCERNING TRADING SYSTEMSMany myths have been created since the genesis of trading systems inthe mid-1970s. The following list will give you some of the misconceptions that are running wild in this industry. We will elaborate more onthese topics throughout the rest of the chapters in this book.
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• Myth: Only good trading systems cost thousands of dollars.• Fact: We have seen systems that cost less than $100 out performones that cost $10,000. A holy grail does not exist. We personallydon't t h i n k you should pay more than $3000 for a trading system.• Myth: The markets are too chaotic for a simple approach to work.• Fact: The markets aren't really that complex. They are eithertrending or not. When you make a system too smart, it tries tocapture every possible market move. We have seen simple systemscatch a trend and hold it, while more complex systems try to capture every sub movement and end up missing the trend.• Myth: Markets are too different for a single approach to work.• Fact: Personally, we have never seen a single approach work inall markets. However, we have seen systems that work in a majority of markets. If a system works well in the Swiss Franc itshould work in the other currencies without modifications. Usually if a system works in currencies, it will also work well in thefinancials (excluding stock market indexes), again without modifications. A lot of the systems that perform well in these marketscan carry over to the energies, grains and meats. The metals areanother story.• Myth: If a system trades multiple markets, then the parametersneed to be optimized for each individual market.• Fact: If a system is based off of sound market principles then itshould be robust enough to work with similar parameters for allmarkets. Of course there are certain types of parameters thatmay need to be different. A $1500 stop in the S&P is totally different than a &1500 stop in corn. Instead of fixed parameters youshould use market defined parameters (e.g., instead of $1500 whynot use 40% of the average range). By doing this, you can eliminate market by market optimization.• Myth: All the good systems are under the control of multimillion$ CTAs (commodity trading advisors).• Fact: Most successful CTAs do use trading systems. The systems they use are the same systems available to anybody. Manywell-known CTAs use the very simple n-week channel breakoutmethod. The reasons that they are generally more successfulthan individual traders are: (a) they have a lot more money tocapitalize their trading and (b) they trade at such a higher volume that they can utilize portfolio and money managementanalysis.
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• Myth: Markets are constantly changing, therefore systems need tobe reoptimized periodically.• Fact: If a system is designed well and based of sound marketprinciples it should be able to trade any market evolution. Remember, the market is either trending or not. No system will be profitable all of the time. There will be times when a market won'thave any direction and during this time all systems will havedraw downs. Reoptimizing a system will curve fit the most recenthistorical data. Who knows how long the market will continue toact in the same manner.• Myth: I should expect the same return and maximum draw downthat was portrayed when I historically back tested my system.• Fact: I wish this were true. In my experience, you should expect1/2 the profit and twice maximum draw down. There are two reasons for this: (1) a computer simulation cannot exactly duplicatemarket conditions and (2) any historical back test has some levelof optimization. Let's further expand on these two reasons.1. Computers cannot simulate exact market conditions.When testing systems we usually levy a $100 commission/slippage charge for each trade. Traders slipped anywhere from$100 up to $1000 on a one contract basis.2. Any historical hack test has some level of optimization.When a person applies an idea to some historical data andanalyses the performance numbers, I guarantee that theywill change or tweak something and rerun the teat. A traderwill not put his money on something that doesn't performwell historically This optimization is fine, if the trader/developer doesn't get carried away. If too many optimizations aredone, then the system has been perfectly fit to the historicaldata. The only way this type of system will perform well isfor history to exactly repeat itself. Unfortunately, optimization is a necessary evil, for without it nobody could developand test trading systems.• Myth: I can make 100% a year trading futures.• Fact: If someone could consistently do this, then there would beno markets. In my ten years of experience, 1 have never seen asystem do this. I have seen systems do this on a couple of occasions, but never consistently. Most large CTAs aim for 20% to25% return with a minimum of 10% to 15% draw down. Futurestrading should be considered as another asset class. It is a greatway to diversify your portfolio.
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• Myth: I only need to capitalize my account by the amount required to cover margin.• Fact: This is a recipe far disaster. Your worst case draw down isusually ahead of you. Without a buffer, you could be knocked nutof the game within a couple of days of trading. Let's assume youwant to trade the Japanese Yen and you send your broker a checkfor the initial margin ($3000). The next day you get a signal, andyou buy a Japanese Yen contract and by the end of the day youraccount is up $250. You really feel great about yourself and thesystem. The next morning, unfortunately, something occurs inthe far east and the Japanese Yen gaps down 250 points (February 16, 1999 and April 3, 2000). Your account is down $3125. Thenext thing you know, your broker is calling you for more money orhe is liquidating your account.CONCLUSIONWe touched upon some keenly important topics in this chapter. Themost important to remember are:• Don't trade commodity systems unless you have enough riskcapital.• To receive the benefits of a trading system, you must trade it religiously.• Realize the limitations of hypothetical track records.• Don't believe all of those trading system ads or brochures.• Propose the "right" questions to a system vendor.• Educate yourself in the areas of trading systems and technicalanalysis.Read the rest of this book. We hope this chapter hasn't scored youoff from mechanical trading systems. Sometimes the truth initiallyhurts, but in the end it w i l l pay for itself several times over. The truthis most systems will not live up to their billing. If the consumer understands this, then hopefully the ninety percent failure rate of beginningtraders w i l l dramatically decrease.
9WHERE TO START
After you have decided to trade the markets with a mechanical approach, there are several decisions you must make before you can placeyour initial trade. All mechanical systems need daily, weekly, ormonthly input before they can generate a trading decision. Some systems need more input than others. Several basic tools are required toprocess this input and generate actual trading signals.HARDWAREA computer is a necessity for any system trader. It is not that good trading systems are highly computational or need millions of instructionscarried out in a matter of seconds, but tasks that could take a traderseveral hours a day can be accomplished in a matter of minutes withthe aid of a computer. A computer with the following specificationsshould he more than sufficient: 300+mhz processor, 4 gigabyte harddrive, 64 megabytes of ram, 56k modem, color monitor, and internet access. An Apple Macintosh or IBM PC with these specifications wouldwork fine. Trading programs used today are engineered for both platforms, but as in most arenas, the PC platform will have more programsavailable.SOFTWARE
Charting, testing, and database management software make a systemtrader's life much easier. The day-to-day maintenance of a mechanicalsystem can only be done with a computer and software. The chores
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involved with system trading are: data collection, data update, signalcalculation, and position and equity accounting. The number of choresare multiplied by the number of different markets that are beingtraded. A computer and software allows traders to do other thingsthroughout the day. There is a vast array of software packages soldtoday to assist people in their trading. The computer decision is simplecompared to the decision of which software package to buy. The priceof these packages range from only a few dollars to thousands of dollars. The price of the software usually depends on the number of builtin functions. TradeStation by Omega Research does just abouteverything you could possibly need to trade a mechanical system: youcan download data on all markets, update your database, design andimplement your trading system, monitor your system's progress, chartdifferent indicators, and receive real time quotes. This type of software is relatively expensive (more than $2000) and is not absolutelynecessary. With a little bit of daily elbow grease, you can trade a system with a much less expensive software package. In fact, a good portion of the systems that are available at the retail level can beprogrammed into a simple spreadsheet, It is up to you, do you spendmore money and less effort or less money and more effort. Whateversoftware package you decide to purchase, it should at minimum havethe following features:• Display bar charts over different time periods (daily, weekly,monthly).• Database management (update and maintain price data).
• Display different indicators.• Display data in tabular form.Optional features include:• Display intraday bar charts.• Drawing capabilities (tr