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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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The simple moving average is the average price of a specific data set. For example, if we were interested in knowing the 200-day simple moving average for U.S. dollar-Japanese yen (see Figure 1.1), we would add up the settlement prices of the prior 200 trading days and then divide the total by 200. Upon the completion of each new trading day, the data from the oldest day—201 trading days ago—drops from our moving average calculation and is replaced by the new settlement price, hence the term moving average.
The theory behind using a moving average is that if the market is in a significant uptrend, prices should not be weak enough to fall below the 200-day moving average. Once the market is weak enough to breach the moving average, this theoretically suggests the end of the old uptrend and start of a new downtrend.
Because this utilization of the moving average line not only produces objective trading signals but also quantifies risk, it is considered to be not only a technical indicator but also a mechanical trading system, albeit the most simplistic one imaginable. Since buy and sell signals are generated whenever the moving average line is violated, it is known as a stop-and-re-verse trading system. It is a stop-and-reverse system because whenever the
Dispelling Myths and Defining Terms
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[ [Apr 02 ^ay |Jun [jul |Aug |Sep |0ct |Nov
FIGURE 1.1 Spot U.S. dollar-Japanese yen with 200-day ©2004 CQG, Inc. All rights reserved worldwide.
|Dec
moving
average.
market becomes weak enough to close below the moving average line, we not only exit all existing long positions but also initiate new short positions.
Although a 200-day simple moving average is by no means the most successful mechanical trading system, it clearly illustrates what technicians mean when they speak of objective, mathematical indicators. It is this objectivity of trading signals derived from mathematical technical analysis that makes mathematical technical analysis the indispensable foundation of the vast majority of mechanical trading systems.
MECHANICAL TRADING SYSTEMS: A DEFINITION

Mechanical trading systems can be defined as methods of generating trading signals and quantifying risk that are independent of an individual trader’s discretion. Although the advantages in utilizing a mechanical trading system are manifold, most market participants agree that their greatest benefit is the tempering of destructive trader “emotionalism”—which is considered to be the enemy of all successful market participants—from the decision-making process.
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MECHANICAL TRADING SYSTEMS
Obviously mechanical trading systems can be developed based on any number of objective criteria including interest rate differentials, gross domestic product, or earnings per share. Although this book in no way negates the validity of such fundamental tools in system development,9 I do argue that an inherent limitation in using such tools is that they require an indepth understanding of a particular market or trading instrument.
By contrast, mathematical technical indicators do not require any particular specialized knowledge of the underlying fundamentals affecting a particular market on the part of system developers. This absence of expertise thereby allows traders to apply their system as readily to Asian equities or live cattle, soybeans or foreign exchange, sugar or natural gas. Although obvious benefits gained by participating in diverse markets will be examined in detail later, for now let me suggest that diversification into various low to negatively correlated asset classes increases the likelihood of improved rates of return on investment and often reduces the severity of peak-to-valley drawdowns in equity.10
DEFINING THE TIME FRAMES

Often traders will define themselves by the time frame of their positions. The problem is that there is no universally accepted definition of what separates long, intermediate, and short-term traders. For the sake of simplicity and consistency, I will designate some time parameters to each of these terms. As used in this book, long-term traders are those who attempt to profit from trends lasting anywhere from 1 to 6 months. Intermediate-term traders are those who hold trades from 10 days to 1 month, and short-term traders are those holding positions for less than 10 days.
TECHNICAL ANALYSIS: WHY IT WORKS

As shown in later chapters, technical analysis can be used to develop two different types of mechanical trading systems: price-driven systems or indicator-driven systems (along with a combination of the two). Both types of trigger events can be used to produce successful trading systems because they capitalize on recurring psychological conditions in the market.
Psychological Significance of Price Triggers: Horizontal Support and Resistance Levels
To understand why technical analysis works in terms of market psychology, let us examine the heating oil futures market, which began trading on Nymex during the late 1970s.
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