MechanicalTradingSystems

Pairing Trader Psychology with Technical Analysis

RICHARD L. WEISSMAN

John Wiley & Sons, Inc.

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MechanicalTradingSystems

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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe,

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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

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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