Chapter 1
Appraising theory
If you are happy to trade using accepted practice and have no desire to probe the boundaries of technical analysis, there are plenty of solid technical trading programs at your disposal that will accommodate a more conventional approach. Many of these techniques have been tested Over time and proven effective, so all that is required on your part is familiarisation. The weakest link initially is you, as you come to terms with the strategy, tools and general application in real time. However, the potential problem with such programs Over the long term is that you will outgrow the software. Some of you may say that it is unlikely you will want to move beyond your present software; however, the continual learning curve that develops as you are trading and that leads to a deeper understanding of the market eventually has most people asking questions that basic and very rigid trading programs are simply unable to answer. This does not imply that the product is suddenly inferior, just that you are moving beyond its capabilities.
Over the course of this chapter, I will develop and test a basic trading strategy, and discuss which factors within the testing results to focus on. The discussion will highlight the factors that will then be used to compare the test results of each new concept that is tested throughout the rest of the book.
Outlining the testing program
If you are going to develop strategies and continually probe the boundaries of technical analysis, a quality testing program is essential in today’s trading environment. For years such products simply did not exist, unless you were prepared to purchase TradeStation. (MetaStock does include the system tester; however, in my opinion it is a very rudimentary feature when compared to specialised development software such as TradeSim.) In the era before simulation and development software, research and development was a very laborious task — to put it mildly. It involved many spreadsheets, real-time trading and a very basic assessment process of historical data in order to arrive at what was usually a questionable result. For example, I spent a considerable period of time refining the parameters for my relative percentage trailing stop. The best I could determine from this was that a longer period of around 21 days was more appropriate than the more accepted five periods applied to many trailing stops, and that 2.7 seemed like an ideal multiplication factor. While this worked well in real time, by the time everything was running smoothly the development process from start to finish had taken almost two years. Then I discOvered TradeSim. I spent one rainy afternoon reviewing my favourite trailing stop using TradeSim and, would you believe it, the program identified that a 2.7×(21) relative percentage trailing stop was ideal. What had taken me almost two years, was achieved in one afternoon. While this might disappoint some, I was ecstatic as it indicated that TradeSim had the genuine capacity to identify suitable values relative to real-time application. Occasionally one program will stand out as beneficial to your trading activities.
With regards to technical trading programs, there is an ever-increasing selection of products all bidding for the trader’s dollar. Generally, they are very similar in content and functionality. They will all have their own unique features in one form or another and that one special indicator that distinguishes them from their competitor; however, by and large, the differentiation between products is usually minimal with many functions once considered specialised now commonplace among most trading packages. While some programs do have custom indicators, similar versions seem to appear relatively quickly so any benefit from a proprietary indicator is often limited.
TradeSim does not fit into this category. It is not trading software but rather a development program that allows the trader to evaluate strategies in an instant — literally. TradeSim cOvers the mechanical side of trading and, providing your technique can be coded using MetaStock language or BullScript, you are in business. (If you are not interested in learning how to code, you are neglecting one of the most important elements within your strategy blueprint — the development phase. Trading is only the end result of development through repeated testing, whether this is done the old-fashioned way using paper trading in real time or by using a simulation program such as TradeSim. You should never apply a strategy that has not undergone rigorous assessment.)
Under normal circumstances, I avoid providing excessive detail on individual programs; however, TradeSim is used extensively throughout this book in an attempt to quantify the effectiveness — or, in some case, the incompetence — of different techniques and practices. With this in mind, I considered you needed to have some insight as to how such results were attained and the validity of the results shown. I also felt that you needed to have a basic understanding of how to interpret the information included in the results. Many of the values are fairly seIf-explanatory, and these will not be cOvered; however, some of the more important aspects of the development process will receive attention where necessary.
Testing parameters and analysis process
As mentioned, I used TradeSim to simulate the trading process for various techniques and processes, and so compare the effectiveness of each. TradeSim comes with a 250-page instruction manual that is a book in itself, so, as you can appreciate, the list of features is comprehensive. As it is impossible to cOver all of the features in TradeSim and do the program justice, I will limit the discussion to the basics of getting started. While TradeSim is designed to test at the most intricate levels, it is not essential to know the inner workings of all the available features in order to produce reliable results relative to how we intend to approach the market.
For publication purposes, I have condensed the reports by removing any areas of duplication; however, none of the values has been altered in any way. The actual results you see are as produced by TradeSim. While I am unable to guarantee the accuracy of the results produced by TradeSim, I have no reason to question the validity of the simulation process or the results produced. During my extensive use of the program Over years of application, I have seldom experienced results that led me to question the integrity of the software. At the end of each chapter, I have included the necessary coding that will allow you to independently test the results for yourself.
For testing purposes, including all discussions from this point, I have applied the following parameters:
- all strategies are tested on the top 300 stocks listed on the ASX
- testing commenced on 1 January 2000 and concluded on 30 June 2005
- I have loaded 350 weeks or 1500 days, depending on the time frame being assessed.
I arrived at the results included in this book by, firstly, evaluating each step of the development process using Monte Carlo analysis. I then located an individual simulation that was consistent with the average results produced by the Monte Carlo process.
Monte Carlo analysis
Before you start scratching your head about Monte Carlo analysis, you first need to understand how TradeSim operates. TradeSim trades in the identical manner to real-time application in that, once full capital allocation has been achieved, all further trades are ignored until an existing position is closed. This is then carried through the entire testing period, whereby a new position is opened only when trading capital becomes available. One of the more obvious problems with some older testing programs is that they use the same starting point; therefore, the same sequence of trades unfolds leading to the same inevitable...