Contents

Cover

Series

Title Page

Copyright

Dedication

Preface to the Fifth Edition

COHERENCE

MORE STRATEGIES, MORE PROGRAMS AND SPREADSHEETS

UPDATED CHARTS

SEARCHING FOR ROBUSTNESS

COMPANION WEBSITE

WITH APPRECIATION

Chapter 1: Introduction

THE EXPANDING ROLE OF TECHNICAL ANALYSIS

CONVERGENCE OF TRADING STYLES IN STOCKS AND FUTURES

A LINE IN THE SAND BETWEEN FUNDAMENTALS AND TECHNICAL ANALYSIS

PROFESSIONAL AND AMATEUR

RANDOM WALK

DECIDING ON A TRADING STYLE

MEASURING NOISE

MATURING MARKETS AND GLOBALIZATION

BACKGROUND MATERIAL

RESEARCH GUIDELINES

OBJECTIVES OF THIS BOOK

PROFILE OF A TRADING SYSTEM

A WORD ABOUT THE NOTATION USED IN THIS BOOK

AND FINALLY . . .

Chapter 2: Basic Concepts and Calculations

ABOUT DATA AND AVERAGING

ON AVERAGE

PRICE DISTRIBUTION

MOMENTS OF THE DISTRIBUTION: VARIANCE, SKEWNESS, AND KURTOSIS

STANDARDIZING RISK AND RETURN

THE INDEX

STANDARD MEASUREMENTS OF PERFORMANCE

PROBABILITY

SUPPLY AND DEMAND

Chapter 3: Charting

FINDING CONSISTENT PATTERNS

WHAT CAUSES THE MAJOR PRICE MOVES AND TRENDS?

THE BAR CHART AND ITS INTERPRETATION BY CHARLES DOW

CHART FORMATIONS

TRENDLINES

ONE-DAY PATTERNS

CONTINUATION PATTERNS

BASIC CONCEPTS IN CHART TRADING

ACCUMULATION AND DISTRIBUTION’BOTTOMS AND TOPS

EPISODIC PATTERNS

PRICE OBJECTIVES FOR BAR CHARTING

IMPLIED STRATEGIES IN CANDLESTICK CHARTS

PRACTICAL USE OF THE BAR CHART

EVOLUTION IN PRICE PATTERNS

Chapter 4: Charting Systems and Techniques

DUNNIGAN AND THE THRUST METHOD

NOFRI’S CONGESTION-PHASE SYSTEM

OUTSIDE DAYS WITH AN OUTSIDE CLOSE

INSIDE DAYS

PIVOT POINTS

ACTION AND REACTION

CHANNEL BREAKOUT

MOVING CHANNELS

COMMODITY CHANNEL INDEX

WYCKOFF’S COMBINED TECHNIQUES

COMPLEX PATTERNS

A STUDY OF CHARTING PATTERNS

BULKOWSKI’S CHART PATTERN RANKINGS

Chapter 5: Event-Driven Trends

SWING TRADING

CONSTRUCTING A SWING CHART USING A SWING FILTER

POINT-AND-FIGURE CHARTING

THE N-DAY BREAKOUT

Chapter 6: Regression Analysis

COMPONENTS OF A TIME SERIES

CHARACTERISTICS OF THE PRICE DATA

LINEAR REGRESSION

LINEAR CORRELATION

NONLINEAR APPROXIMATIONS FOR TWO VARIABLES

TRANSFORMING NONLINEAR TO LINEAR

EVALUATION OF TWO-VARIABLE TECHNIQUES

MULTIVARIATE APPROXIMATIONS

ARIMA

BASIC TRADING SIGNALS USING A LINEAR REGRESSION MODEL

MEASURING MARKET STRENGTH

Chapter 7: Time-Based Trend Calculations

FORECASTING AND FOLLOWING

PRICE CHANGE OVER TIME

THE MOVING AVERAGE

GEOMETRIC MOVING AVERAGE

ACCUMULATIVE AVERAGE

RESET ACCUMULATIVE AVERAGE

DROP-OFF EFFECT

EXPONENTIAL SMOOTHING

PLOTTING LAGS AND LEADS

Chapter 8: Trend Systems

WHY TREND SYSTEMS WORK

BASIC BUY AND SELL SIGNALS

Bands and Channels

APPLICATIONS OF A SINGLE TREND

COMPARISON OF MAJOR TREND SYSTEMS

TECHNIQUES USING TWO TRENDLINES

Multiple Trends and Common Sense

COMPREHENSIVE STUDIES

Selecting the Right Trend Method and Speed

MOVING AVERAGE SEQUENCES: SIGNAL PROGRESSION

EARLY EXITS FROM A TREND

MOVING AVERAGE PROJECTED CROSSOVERS

Chapter 9: Momentum and Oscillators

MOMENTUM

DIVERGENCE INDEX

OSCILLATORS

DOUBLE-SMOOTHED MOMENTUM

VELOCITY AND ACCELERATION

HYBRID MOMENTUM TECHNIQUES

MOMENTUM DIVERGENCE

SOME FINAL COMMENTS ON MOMENTUM

Chapter 10: Seasonality and Calendar Patterns

A CONSISTENT FACTOR

THE SEASONAL PATTERN

POPULAR METHODS FOR CALCULATING SEASONALITY

SEASONAL FILTERS

SEASONALITY AND THE STOCK MARKET

COMMON SENSE AND SEASONALITY

Chapter 11: Cycle Analysis

CYCLE BASICS

UNCOVERING THE CYCLE

MAXIMUM ENTROPY

CYCLE CHANNEL INDEX

SHORT CYCLE INDICATOR

PHASING

Chapter 12: Volume, Open Interest, and Breadth

A SPECIAL CASE FOR FUTURES VOLUME

VARIATIONS FROM THE NORMAL PATTERNS

STANDARD INTERPRETATION

VOLUME INDICATORS

BREADTH INDICATORS

INTERPRETING VOLUME AND BREADTH SYSTEMATICALLY

AN INTEGRATED PROBABILITY MODEL

INTRADAY VOLUME PATTERNS

FILTERING LOW VOLUME

MARKET FACILITATION INDEX

Chapter 13: Spreads and Arbitrage

DYNAMICS OF FUTURES INTRAMARKET SPREADS

CARRYING CHARGES

SPREADS IN STOCKS

SPREAD AND ARBITRAGE RELATIONSHIPS

RISK REDUCTION IN SPREADS

ARBITRAGE

THE CARRY TRADE

CHANGING SPREAD RELATIONSHIPS

INTERMARKET SPREADS

Chapter 14: Behavioral Techniques

MEASURING THE NEWS

EVENT TRADING

COMMITMENT OF TRADERS REPORT

OPINION AND CONTRARY OPINION

FIBONACCI AND HUMAN BEHAVIOR

ELLIOTT'S WAVE PRINCIPLE

PRICE TARGET CONSTRUCTIONS USING THE FIBONACCI RATIO

FISCHER'S GOLDEN SECTION COMPASS SYSTEM

W. D. GANN—TIME AND SPACE

FINANCIAL ASTROLOGY

Chapter 15: Pattern Recognition

PROJECTING DAILY HIGHS AND LOWS

TIME OF DAY

OPENING GAPS

WEEKDAY, WEEKEND, AND REVERSAL PATTERNS

COMPUTER-BASED PATTERN RECOGNITION

ARTIFICIAL INTELLIGENCE METHODS

Chapter 16: Day Trading

IMPACT OF TRANSACTION COSTS

KEY ELEMENTS OF DAY TRADING

TRADING USING PRICE PATTERNS

INTRADAY BREAKOUT SYSTEMS

INTRADAY VOLUME PATTERNS

INTRADAY PRICE SHOCKS

Chapter 17: Adaptive Techniques

ADAPTIVE TREND CALCULATIONS

ADAPTIVE VARIATIONS

OTHER ADAPTIVE MOMENTUM CALCULATIONS

ADAPTIVE INTRADAY BREAKOUT SYSTEM

AN ADAPTIVE PROCESS

CONSIDERING ADAPTIVE METHODS

Chapter 18: Price Distribution Systems

MEASURING DISTRIBUTION

USE OF PRICE DISTRIBUTIONS AND PATTERNS TO ANTICIPATE MOVES

DISTRIBUTION OF PRICES

STEIDLMAYER’S MARKET PROFILE

USING DAILY DISTRIBUTIONS TO IDENTIFY SUPPORT AND RESISTANCE

Chapter 19: Multiple Time Frames

TUNING TWO TIME FRAMES TO WORK TOGETHER

ELDER’S TRIPLE-SCREEN TRADING SYSTEM

ROBERT KRAUSZ’S MULTIPLE TIME FRAMES

MARTIN PRING’S KST SYSTEM

Chapter 20: Advanced Techniques

MEASURING VOLATILITY

USING VOLATILITY FOR TRADING

TRADE SELECTION USING VOLATILITY

LIQUIDITY

TRENDS AND PRICE NOISE

TRENDS AND INTEREST RATE CARRY

EXPERT SYSTEMS

FUZZY LOGIC

FRACTALS, CHAOS, AND ENTROPY

NEURAL NETWORKS

GENETIC ALGORITHMS

REPLICATION OF HEDGE FUNDS

Chapter 21: System Testing

EXPECTATIONS

IDENTIFYING THE PARAMETERS

SELECTING THE TEST DATA

TESTING INTEGRITY

SEARCHING FOR THE BEST RESULT

VISUALIZING AND INTERPRETING TEST RESULTS

LARGE-SCALE TESTING

REFINING THE STRATEGY RULES

ARRIVING AT VALID TEST RESULTS

COMPARING THE RESULTS OF TWO SYSTEMS

PROFITING FROM THE WORST RESULTS

RETESTING FOR CHANGING PARAMETERS

TESTING ACROSS A WIDE RANGE OF MARKETS

PRICE SHOCKS

ANATOMY OF AN OPTIMIZATION

SUMMARIZING ROBUSTNESS

Chapter 22: Practical Considerations

USE AND ABUSE OF THE COMPUTER

EXTREME EVENTS

GAMBLING TECHNIQUES—THE THEORY OF RUNS

SELECTIVE TRADING

SYSTEM TRADE-OFFS

TRADING LIMITS AND DISCONNECTED MARKETS

SILVER AND NASDAQ—TOO GOOD TO BE TRUE

SIMILARITY OF SYSTEMATIC TRADING SIGNALS

Chapter 23: Risk Control

MISTAKING LUCK FOR SKILL

RISK AVERSION

LIQUIDITY

MEASURING RETURN AND RISK

LEVERAGE

LEVERAGE BASED ON EXPOSURE

INDIVIDUAL TRADE RISK

KAUFMAN ON STOPS AND PROFIT-TAKING

RANKING OF MARKETS FOR SELECTION

PROBABILITY OF SUCCESS AND RUIN

ENTERING A POSITION

COMPOUNDING A POSITION

EQUITY TRENDS

INVESTING AND REINVESTING: OPTIMAL F

COMPARING EXPECTED AND ACTUAL RESULTS

Chapter 24: Diversification and Portfolio Allocation

DIVERSIFICATION

CHANGING CORRELATIONS

TYPES OF PORTFOLIO MODELS

CLASSIC PORTFOLIO ALLOCATION CALCULATIONS

FINDING OPTIMAL PORTFOLIO ALLOCATION USING EXCEL'S SOLVER

KAUFMAN'S GENETIC ALGORITHM SOLUTION TO PORTFOLIO ALLOCATION (GASP)

VOLATILITY STABILIZATION

Appendix 1: Statistical Tables

PROBABILITY DISTRIBUTIONS TABLES

Appendix 2: Matrix Solution to Linear Equations and Markov Chains

DIRECT SOLUTION AND CONVERGENCE METHOD

GENERAL MATRIX FORM

DIRECT SOLUTION

CONVERGENCE METHOD

Appendix 3: Trigonometric Regression for Finding Cycles

SINGLE-FREQUENCY TRIGONOMETRIC REGRESSION

TWO-FREQUENCY TRIGONOMETRIC REGRESSION

Bibliography

About the Companion Website

Index

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Copyright © 2005, 2013 by Perry J. Kaufman. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Kaufman, Perry J.
Trading systems and methods / Perry J. Kaufman. — 5th ed.
p. cm.
Rev. ed. of: New trading systems and methods. 4th ed. c2005.
Includes bibliographical references and index.
ISBN 978-1-118-04356-1 (cloth) — 978-1-118-22224-9 (ebk) — 978-1-118-26092-0 (ebk) —
978-1-118-23603-1 (ebk)
1. Commodity exchanges—Statistical methods. 2. Technical analysis (Investment analysis) I. Kaufman, Perry J. New trading systems and methods. II. Title.
HG6046.K34 2013
332.64′4–dc23
2012030903

To Barbara

Preface to the Fifth Edition

In the past eight years, since the last edition, our industry has continued to change. The extraordinary bull market of the late 1990s, followed by the bursting of the tech bubble in 2000 seemed to be events that could never be overshadowed, but the subprime collapse in 2007 proved us wrong. We learned what risk was all about, when money was pulled from every possible investment at the same time. In many cases, the investments that were liquidated had no other relationship than having profits that were needed to cover losses elsewhere. The principles of diversification held true, but we saw the worst-case scenario, where everything moved in the same way at the same time. It was an event with a very low probability, but not zero.

During the years that have followed, we would expect much more focus on risk management, rather than risk measurement. Understanding how to reduce risk before the fact is much more productive than identifying it afterward. Some hedge funds, following in the steps of Long-Term Capital Management, have chosen to see this as a rare event, not likely to be repeated. The rationale for this is that, in order to reduce the chances of large risk, you must also reduce returns. They see investors as preferring the small chance of a large loss to the less acceptable assurance of lower profits. I won't try to judge the merits of this decision.

On the other hand, we should all understand the best choices for controlling risk. With that in mind, many of the changes in this edition address risk control, from the individual trade level, to the strategy rules, to the portfolio.

COHERENCE

One of the improvements in this edition is the added coherence from one section to another and from one chapter to another. There will be references, both forward and backward, showing similarities between many techniques. By incorporating those references, some of the duplication has been removed. Considerable effort was made to use the same notation throughout the book, in hope that it will make the formulas easier to understand. You will also find that there is a greater attempt to make this material flow from section to section as a continuous learning process.

MORE STRATEGIES, MORE PROGRAMS AND SPREADSHEETS

Each year brings new ideas, and many articles and books have shed light on new techniques or better ways to approach an old problem. Wherever possible, those ideas have been added here, with references to the original material. There is more cross-pollination with the securities industry, and you will find more terms now used by both futures and stock traders.

Examples make learning easier, and this edition has many more examples, along with more programs and spreadsheets that will help you take whichever ideas are appealing and try them on your own. Wherever possible, the spreadsheet code uses “offset” to allow the calculation periods to be changed. These examples continue to use TradeStation and Excel, which remain the most popular tools. While there are many other choices, code from these two sources can be easily converted to other programs.

UPDATED CHARTS

Along with more examples, many of the old examples and charts have been brought up to date. While there may be an historic interest in market patterns during the 1970s and 1980s, the recent 10 years provide dramatic price movements and seem more relevant. We would all agree that it's good for a strategy to have been profitable in the 1980s, but more important that it succeeded during the past 5 or 10 years. In many cases, the old patterns are still unique and should not be ignored, but every book has its limits.

SEARCHING FOR ROBUSTNESS

The goal of a system developer and/or a trader is to find or create a trading method that will work in many different situations, hopefully across many different markets, and keep working for as long as possible. A solution that is robust satisfies those objectives. Because if its importance, there are comments throughout the book addressing the robustness of various methods and ways to enhance that quality. Chapter 21, System Testing, addresses this directly, but it is not the only place.

Robustness is an easy concept to understand, but a robust strategy has a return and risk profile that is not as attractive as one that has been fitted to the data. Success with fewer rules over more markets and data yields robustness, but at the price of lower returns and higher risk. It is necessary to understand and embrace the natural risk of a strategy and market in order to succeed in the long term. If you try to engineer all of the risk out of a trade, it will only surface somewhere else when it is least welcome.

COMPANION WEBSITE

The companion website has been greatly expanded with both TradeStation programs (Version 9) and Excel 2010 spreadsheets. It is expected that MetaStock code will be added in the near future. There is also a list of contents at the back of this book. Whenever a website program relates to a section of the book, there is an icon in the margin to remind you of its availability. Hopefully, this will make the development and verification of new ideas more convenient.

WITH APPRECIATION

This book draws on the hard work and creativity of hundreds of traders, financial specialists, engineers, and many others who are passionate about the markets. They continue to redefine the state-of-the-art and provide all of us with both profitable techniques and valuable tools.

A long overdue thanks to Janette Perez of TradeStation for her generous help. My gratitude to Pamela van Giessen and Emilie Herman of John Wiley & Sons, who continue to provide immeasurable help and encouragement. And to my wife, Barbara, whose everlasting support is only enhanced by rolling her eyes whenever I say that this is my last book, ever.

As a final note, I would like to thank all the previous readers who sent messages about typographical errors, omissions, and just simple errors. They have all been corrected. It makes this edition that much better.

PERRY J. KAUFMAN
Freeport, Grand Bahama
November 2012

CHAPTER 1

Introduction

It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change.

—Charles Darwin

Let’s start by redefining the term technical analysis. Technical analysis is the systematic evaluation of price, volume, breadth, and open interest, for the purpose of price forecasting. A systematic approach may simply use a bar chart and a ruler, or it may use all the calculation power available. Technical analysis may include any quantitative analysis as well as all forms of pattern recognition. Its objective is to decide, in advance, where prices will go over some time period, whether 1 hour, 1 day, or 5 years. Technical analysis must have clear and complete rules.

Technical analysis is no longer just the study of chart patterns or the identification of trends. It encompasses intramarket analysis, complex indicators, mean reversion, and the evaluation of test results. It can use a simple moving average or a neural network to forecast price moves. This book serves as a reference guide for all of these techniques, puts them in some order, and explains the functional similarities and differences for the purpose of trading. It includes some aspects of portfolio construction and multilevel risk control, which are integral parts of successful trading.

THE EXPANDING ROLE OF TECHNICAL ANALYSIS

Quantitative methods for evaluating price movement and making trading decisions have become a dominant part of market analysis. Those who do not use methods such as overbought and oversold indicators are most likely to watch them along the bottom of their screen. The major financial networks are always pointing out price trends and double bottoms, and are quick to say that a price move up or down was done on low volume to show that it might be unreliable. The 200-day moving average seems to be the benchmark for trend direction. These comments show the simplicity and the acceptance of technical analysis.

Events beginning in 2002 cast doubt on the integrity of the research produced by major financial houses that have a conflict between financing/underwriting and retail brokerage. The collapse of Enron has caused us to question the earnings, debt, quality-of-business, and other company data released to the public by large and small firms. It is not surprising that more quantitative trading methods have been adopted by research firms. When decisions are made with clear rules and calculations that can be audited, those analysts recommending buys and sells are safe from scrutiny.

Extensive quantitative trading exists around the world. Interest rate arbitrage is a major source of revenue for banks. Location arbitrage is the process that keeps the price of gold and other precious metals the same all over the globe. Program trading keeps the price of the overall stock market from diverging from S&P futures and SPY (the SPDR ETF) prices. Recently these fully automated systems have been called algorithmic trading.

If you don’t think of arbitrage as technical trading, then consider market neutral strategies, where long and short positions are taken in related markets (pairs trading) in order to profit from one stock rising or falling faster than the other. If you change your time horizon from hours and days to milliseconds, you have high frequency trading. You might prefer to take advantage of the seasonality in the airline industry or try your hand trading soybeans. Both have clear seasonal patterns as well as years when other factors (such as a disruption in energy supply) overwhelm the seasonal factors. Trading seasonal patterns falls under technical analysis.

Technology that allows you to scan and sort thousands of stocks, looking for key attributes—such as high momentum, a recent breakout, or other indicator values—is also technical analysis on a broader scale. High frequency trading, arbitrage that lasts only milliseconds, has become a profit center for large financial institutions, but involves placing computer equipment as close to the source of the exchange price transmission as possible—a contentious issue. High frequency trading is credited for adding liquidity by increasing volume in equities trading, but has also been blamed (perhaps unfairly) for spectacular, highly volatility price moves.

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!