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Mechanical trading systems - Weissman R.L.

Weissman R.L. Mechanical trading systems - Wiley publishing , 2005 . - 240 p.
ISBN 0-471-65435-3
Download (direct link): mechanicaltradingsystems2005.pdf
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Mathematical Technical Analysis
19
technical analysis, with his adaptive moving average, attempts to address the issue of choosing between longer- and shorter-term moving averages by introducing a moving average that is attuned to market volatility, moving slower during periods of low volatility (i.e., sideways consolidation) and quicker in high-volatility or trending environments.3
Avoiding Whipsaws versus Improving Risk/Reward Everything in system development—as in life in general—is a trade-off. Our trade-off when working with moving averages is choosing between speeds of response to changes in trend and the number of false trend-following signals we are willing to endure.
Other solutions to this issue, besides the shorter- and longer-term moving averages, use of weighted moving averages, and the adaptive moving average, include the introduction of a second condition onto the moving average indicator in hopes of confirming valid signals and filtering out false breakouts. (False breakouts are also known as whipsaws because trend-following traders buying or selling on such signals get whipped into loss after loss until the market experiences a sustainable trend.) Although such confirmation patterns are limited only by the technician’s imagination, the basic types of patterns are:
• Time-driven patterns, such as whipsaw waiting periods and modification of time horizons
• Percentage penetrations of the moving average
• The introduction of a second indicator or price-oriented trigger, such as the breaking of new highs or lows or the 10-period momentum indicator breaking above or below the zero level
Time-Driven Confirmation Patterns The concept of a whipsaw waiting period is fairly straightforward and simple. Instead of entry based on fulfillment of the indicator-driven trigger of settling above or below the moving average (as illustrated by Figure 2.1), now the indicator-driven trigger requires that the market not only settles above the moving average, but that it does so for a consecutive number of time periods (as shown in Figure 2.2).4 Note: The trade results examined throughout this chapter just illustrate the different types of strategies employed. When we compare trading systems in later chapters, we will analyze the results on multiple asset classes with low to negative correlations to ensure the robustness of each system.
The other major flavor of time-driven patterns is that of modifying the time horizon employed, from 30-day to 30-minute moving averages. The premise behind changing the duration of moving averages is that when markets are trending, longer-term moving averages will be profitable. By contrast, shorter-term moving averages should prove more successful in
FIGURE 2.1 Spot British pound-U.S. dollar with 26-day moving average as trigger—trade summary at bottom.
Note: All trade summaries include $100 round-turn trade deductions for slippage and commissions. ©2004 CQG, Inc. All rights reserved worldwide.
FIGURE 2.2 Pound-U.S. dollar using 3-day whipsaw waiting period on a 26-day moving average trading system. Includes data from December 31, 1997, to December 31, 2003.
Note: All trade summaries include $100 round-turn trade deductions for slippage
and commissions. ©2004 CQG, Inc. All rights reserved worldwide.
20
Mathematical Technical Analysis
21
range-bound markets since 30- or 60-minute bar charts will have a higher probability of catching the short-term trend within the longer-term trading range (see Figures 2.3 and 2.4).
The assumption inherent in choosing longer- or shorter-term moving averages is the trader’s ability to determine whether the market is a trending or mean reversion phase. This ability suggests either subjective judgment on the part of the trader or the introduction of an additional mathematical technical indicator, such as volatility or average directional movement index (ADX) to quantify the market’s propensity to trend.6
Percentage Penetrations of the Moving Average Another popular method of filtering out false signals generated by moving averages is the introduction of a percentage penetration prerequisite known as a moving average envelope. These envelopes are constructed by adding and subtracting a percentage of the moving average. Valid trading signals are generated when the market settles beyond the upper or lower envelopes of the moving average (see Figure 2.5).
Although moving average envelopes are traditionally used to filter out false trend-following signals, they also can be used as countertrend
FIGURE 2.3 February 2004 Nymex crude oil and 9- and 26-day crossover. Includes data from December 31, 1997, to December 31, 2003.
Note: All trade summaries include $100 round-turn trade deductions for slippage
and commissions. ©2004 CQG, Inc. All rights reserved worldwide.
FIGURE 2.4 February 2004 Nymex crude oil using 60-minute bars and 9- and 26-period moving average crossovers. Includes data from December 31, 1997, to December 31, 2003.
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