MechanicalTradingSystems
Pairing Trader Psychology with Technical Analysis
RICHARD L. WEISSMAN
John Wiley & Sons, Inc.
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MechanicalTradingSystems
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MechanicalTradingSystems
Pairing Trader Psychology with Technical Analysis
RICHARD L. WEISSMAN
John Wiley & Sons, Inc.
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Copyright 2005 by Richard L. Weissman. All rights reserved.
CQG charts are copyright 2004 CQG, Inc. All rights reserved worldwide.
Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada
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For my wife, Pamela Nations-Weissman, whose vision inspiredthis manuscript, and also for my parents, whose belief and support
guided me through the early years
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Every battle is won before it is ever fought.
Sun Tzu
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Preface xiii
Acknowledgments xix
CHAPTER 1 Dispelling Myths and Defining Terms:Mathematical Technical Analysis andMechanical Trading Systems 1
Dispelling the Myths: The Inefficient Market and the
Hard Road to Profits 1
Technical Analysis: A Definition 3
Mechanical Trading Systems: A Definition 5
Defining the Time frames 6
Technical Analysis: Why it Works 6
Types of Technical Indicators: Trend-Following and Mean
Reversion 10
CHAPTER 2 Mathematical Technical Analysis: A BuildingBlock for Mechanical Trading SystemDevelopment 15
Types of Technical Indicators 16
Trend-Following Indicators: Indicator-Driven Triggers 18
Price-Triggered Trend-Following Indicators: Donchians
Channel Breakout 30
Mean Reversion Indicator-Driven Triggers: Oscillators 31
ix
Contents
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CHAPTER 3 Trend-Following Systems: A Matter of Fortitude 41
Preliminary Considerations 42
Two Moving Average Crossover 50
Ichimoku Two Moving Average Crossover 52
Three Moving Average Crossover 53
Ichimoku Three Moving Average Crossover 54
MACD 55
DMI 56
DMI with ADX 57
Channel Breakout 59
Bollinger Bands 60
Some Comparisons 61
General Rules of Thumb 63
Cutting the Tails of a Systems Distribution 65
Psychological Profile of a Trend-Following Trader 69
CHAPTER 4 Mean Reversion Systems: A Matter of Patience 73
Considerations in Analyzing Intermediate-Term Mean
Reversion Trading Systems 73
Trend-Following Mean Reversion Systems 74
Nondirectionally Biased Mean Reversion Systems 81
Psychological Profile of an Intermediate-Term Mean Reversion
Trader 85
CHAPTER 5 Short-Term Systems: A Matter of Quick-Mindedness 89
Fading the Losing System 89
Liquidity and Volatility 89
Backtested Results 91
Swing Trading with 2-Hour Bars 92
Mean Reversion Systems Using 60-Minute Bars 95
Nondirectionally Biased Mean Reversion Systems 96
Mean Reversion Systems Using 30-Minute Bars 98
x MECHANICAL TRADING SYSTEMS
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15-Minute Bar Systems: RSI Extremes with 50-Hour
Moving Average Filter 101
5-Minute Bar Systems: RSI Extremes with 16.67-Hour
Moving Average Filter 101
Psychological Profile of a Short-term Trader 102
CHAPTER 6 Knowing Oneself: How to ChallengeYour Knowledge 105
Trader Psychology: Ever the Same and Perpetually Changing 105
Time Frames, Trading Systems, and Personality Traits 106
CHAPTER 7 System Development and Analysis: Benefits and Pitfalls 115
System Development Issues: An Overview 115
Benefits of Mechanical Trading Systems 116
Pitfalls of Mechanical Trading Systems 116
Optimization Process 122
System Development Process 148
Data Analysis Process 151
Trading System Philosophy Statements 159
Measuring Trading System Performance 160
CHAPTER 8 Price Risk Management: Schools of Price Risk Managment and Other Considerations 163
Price Risk Management Issues: An Overview 163
Stop-Loss Price Risk Management for Trading Accounts 165
Two Schools of Price Risk Management 165
Stop-Loss Price Risk Management 166
Volumetric Price Risk Management: Martingale and
Anti-Martingale Strategies 168
Value at Risk: An Overview 169
Benefits of Value at Risk 170
Pitfalls of Value at Risk 171
Stress Testing 173
Contents xi
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Psychology of Price Risk Management 173
Mechanical Trading Systems, Drawdowns, and
Trader Confidence 174
CHAPTER 9 Improving the Rate of Return: Improving Returns by Expanding the Comfort Zone 177
Three Types of Diversification 177
Diversification of Parameter Sets 177
Mechanics of Trading System Diversification 180
Psychology of Trading System Diversification 182
CHAPTER 10 Discretion and Systems Trading:Discretion within a Mechanical Framework 185
Discretion and Paradigm Shifts 185
Discretion, Volatility, and Price Shocks 186
Mechanical Discretion 187
Pros and Cons of True Discretion 188
CHAPTER 11 Psychology of Mechanical Trading: Trading Systems and TransformationalPsychology 189
Discipline and Flexibility 189
Flexibility in Body and Mind 191
Knowing Ourselves 192
Single-mindedness: Unraveling the Onion Layers 193
Intuition versus the Psychic Trader Syndrome 194
Transformation via Adherence to Mechanical
Trading Systems 195
Transformational Process: In Life and the Markets 196
Notes 199
References and Further Reading 205
Index 207
xii MECHANICAL TRADING SYSTEMS
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xiii
Preface
In 1987 my father and I purchased a seat on the New York Futures Exchangefor $100 and established a trading account with $25,000. The goal, he ex-plained, was to make $2,500 a week. Although this seemed like an extraor-dinary annualized return on investment, I had heard of legendary traderswho had taken meager sums and transformed them into vast fortunes, andso I embarked on a journey that eventually culminated in the publication ofthis book.
I wish I could tell you that this book contains the secrets of how I ac-complished that formidable g