Building Winning Algorithmic Trading Systems

A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading

Kevin J. Davey

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118778883
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Develop your own trading system with practical guidance and expert advice

In Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Training, award-winning trader Kevin Davey shares his secrets for developing trading systems that generate triple-digit returns. With both explanation and demonstration, Davey guides you step-by-step through the entire process of generating and validating an idea, setting entry and exit points, testing systems, and implementing them in live trading. You'll find concrete rules for increasing or decreasing allocation to a system, and rules for when to abandon one. The companion website includes Davey's own Monte Carlo simulator and other tools that will enable you to automate and test your own trading ideas.

A purely discretionary approach to trading generally breaks down over the long haul. With market data and statistics easily available, traders are increasingly opting to employ an automated or algorithmic trading system—enough that algorithmic trades now account for the bulk of stock trading volume. Building Algorithmic Trading Systems teaches you how to develop your own systems with an eye toward market fluctuations and the impermanence of even the most effective algorithm.

• Learn the systems that generated triple-digit returns in the World Cup Trading Championship
• Develop an algorithmic approach for any trading idea using off-the-shelf software or popular platforms
• Test your new system using historical and current market data
• Mine market data for statistical tendencies that may form the basis of a new system

Market patterns change, and so do system results. Past performance isn't a guarantee of future success, so the key is to continually develop new systems and adjust established systems in response to evolving statistical tendencies. For individual traders looking for the next leap forward, Building Algorithmic Trading Systems provides expert guidance and practical advice.

PART I
A TRADER’S JOURNEY

CHAPTER 1
The Birth of a Trader

It was 1989, and I was California dreamin’. Actually I wasn’t dreaming, I was already in California, living a young single man’s dream. A year or so out of college, I was residing in sunny Manhattan Beach, California, with a small apartment three blocks from the soft white sand so wonderful that they used it to help create Waikiki Beach in Hawaii. I had graduated the year before, summa cum laude, with a bachelor’s degree in aerospace engineering from the University of Michigan, a top-tier engineering school. Then I had turned my back on Massachusetts Institute of Technology (MIT), California Institute of Technology (Cal Tech), Stanford University, Purdue University, and Michigan, all of whom had accepted me in their aerospace master’s degree program. I turned down those great schools to live and work in sunny California, a lifelong dream.

I still remember the precise moment I made that fateful decision. On a bitterly cold winter’s day in Ann Arbor, Michigan, I was walking down South University Avenue to one of my final-semester classes. The wind was blowing so hard in my face that I actually leaned into the wind to see if it would keep me up. At that point, falling face-first onto the ice-covered sidewalk would not have been much worse than feeling the stinging wind in my face. What seemed like a gale-force wind kept me upright, and then I knew—I did not want, or need, to live where it was cold in the winter when aerospace engineering graduates like me were flocking to jobs in sunny southern California. My mind was made up. Sun and sand it was.

A few weeks after graduation, I packed up my belongings, and with my sister Karen as my driving companion, drove cross-country to warm and sunny Los Angeles.

One year later, I was settled in. I had a close group of friends, most of them Midwestern transplants like me. We’d while away the weekends playing beach volleyball, usually capping the day off with a few drinks at a local pub. I loved beach living and all the entertainment it provided. Driving around the beach cities in my little red T-roof sports car, life was pretty good.

But something was missing.

I couldn’t put my finger on it, but I knew this wasn’t the life for me. Well, beach life certainly agreed with me, but my choice of career was the wrong one. Sure, designing future fighter airplanes and working on secret government projects was fulfilling to a degree. But I just didn’t feel like it was my future. I could not see myself doing that kind of work for even 5 years, much less a career of 30 or 40 years. I needed a jolt to wake me up. That jolt came in the form of junk mail that appeared in my mailbox one day, and it changed everything.

The junk mail booklet was from Ken Roberts, a futures and commodities trader. Or at least that is how he presented himself. Looking back on it, he was definitely more of a salesman than a trader. With a nice, folksy smile and a cowboy hat, Ken laid out the riches that awaited anyone brave enough to trade futures, or commodities, as they were more commonly referred to back then.

He had a compelling story in that little booklet of his, and I’ll admit I was quickly hooked. Looking at a chart of sugar, as shown in Figure 1.1, seeing all the potential profit just waiting for me, how could I not be?

FIGURE 1.1 Sugar Skyrocketing = Unlimited Profits?

At that point, words like drawdown, risk of ruin, and emotional control were not in my vocabulary. But massive profits, easy money, and simple trading suddenly were! And with a money-back guarantee, how could I go wrong? It was a risk-free entry pass into a world of unlimited profit potential—or so my naive self-thought. So I sent a check and dreamed that night about all the riches that would soon be flowing my way.

A few weeks later, I received the full trading course. It was a hefty manual, full of charts with profitable examples. Initially, I was duly impressed. But then I started to look a little closer at the details. Turns out the whole course was primarily based on the 1-2-3 head and shoulders pattern. As most traders and investors know, this pattern is a classic chart pattern, as shown in Figure 1.2. It is easy to find on just about any chart you look at—you can find a profitable example or two on most any chart, any instrument, and any time frame.

FIGURE 1.2 Good Head and Shoulders Pattern or Just a False Signal?

The problem is that the head and shoulders pattern gives a lot of false signals and usually looks good only in hindsight. Of course, I did not know that at first. I only knew I could look at a chart, pick out the head and shoulders pattern, and see how well it worked.

I eventually found out I was missing two key pieces of the puzzle. First, when you look at a chart with a head and shoulders or any other pattern in it, it is easy to see the winning trades because you are looking at both the pattern and the outcome of that pattern. If you try hiding the outcome of a pattern, it becomes much more difficult to find the good patterns.

The second key I was missing is that the existence of a pattern, by itself, doesn’t necessarily mean a trade should be taken. If you take every single head and shoulders trade you see, you will soon be broke, as shown in Figure 1.3. Of course, the naive wannabe trader in me was oblivious to this fact.

FIGURE 1.3 Many Head and Shoulders Look Good but Eventually Fail

After a month of dutifully following and paper trading all the head and shoulders signals, and finding most of them to be unprofitable, I sent all my trading records, along with the manual, back for a refund. True to his word, Mr. Roberts refunded my money.

My dream of trading riches was shattered, at least temporarily. On the bright side, I now saw futures as the way to go—I just realized head and shoulders patterns were not going to be the way. Once I abandoned the get-rich-quick idea with the 1-2-3 head and shoulders patterns, I did what many scientific, numbers-oriented people do: I looked to mathematical formulas to help me in my decision making. And I started where many people do: moving averages.

My Moving Average Debacle

I’m sure every trader or investor has seen or used moving averages at some point in their trading career. Moving averages are a great way to see the general market direction, simplifying sometimes chaotic price action. But it comes at a price—lag. Moving averages will always lag whatever their calculation is based on, which can be a major problem.

There are many ways to trade with moving averages. In the simplest method, you simply buy when the price is above the moving average, and sell (or sell short) when price is below the moving average. This scheme works very well during prolonged trends, but gets absolutely hammered during trading range price action (see Figure 1.4).

FIGURE 1.4 Great in Trends, Moving Averages Fail in Trading Ranges

Early market technician pioneers rectified this by employing two, or even three, moving averages. By using more moving averages, the idea was to filter out some of the trading range whipsaw trades, and leave the long-term, profitable trend trades.

After my unsuccessful foray into futures with chart patterns, I was struck by the apparent awesomeness and simplicity of the triple moving average. Looking at a chart, it was easy to see the profitable trades, while the unprofitable whipsaw trades were much harder to detect (see Figure 1.5). During the whipsaw periods, the moving average lines were very close together, and seeing crosses of lines was exceedingly difficult. Obviously, I had learned little from my head and shoulders experience, where what I saw on the chart was deceiving me.

FIGURE 1.5 Triple Moving Average Crossovers Can Be Deceiving

I quickly became a convert to the whole moving average concept, and after a few quick successful tests (I did not understand the need for testing over hundreds of trades at this point, so 10 or 20 trades, computed by hand, were good enough for me!), I decided to fund my first account. Even though I had recently purchased a condo in expensive southern California, which took most of my savings, I was able to scrape together $5...

Table of contents

• Cover
• Series
• Titlepage
• Copyright
• Dedication
• Acknowledgments
• About the Author
• Introduction
• PART I A TRADER’S JOURNEY
• PART II YOUR TRADING SYSTEM
• PART III DEVELOPING A STRATEGY
• PART IV CREATING A SYSTEM
• PART V CONSIDERATIONS BEFORE GOING LIVE
• PART VI MONITORING A LIVE STRATEGY
• PART VII CAUTIONARY TALES
• Conclusion
• APPENDIX A Monkey Trading Example, TradeStation Easy Language Code
• APPENDIX B Euro Night Strategy, TradeStation Easy Language Format
• APPENDIX C Euro Day Strategy, TradeStation Easy Language Format
• About the Companion Web Site
• Index
• End User License Agreement