Trading Systems and Methods, 5th edition – Perry J. Kaufman

PERRY J. KAUFMAN has over thirty years of experience in the equity and derivatives markets. A prominent expert on systematic trading, he travels internationally, lecturing to funds, governments, and portfolio managers. He began his career in the aerospace industry, working on the navigation and control systems of the Gemini space program. The markets captured his attention in the early 1970s, and he was one of the first to develop computer models for making market decisions. Kaufman developed a portfolio optimization program that operates on disjoint equity series output from a trading environment. He has created market-neutral strategies, stat-arb trading methods, short-term program trading for cash, and derivative market instruments for institutional and commercial applications. Kaufman was the first chairman of the advisory board of the Vermont Securities Institute, and has served on the Director’s Committee of Columbia University’s Center for the Study of Futures Markets, founding the Journal of Futures Markets. In 2002, he taught a landmark course in systematic trading at the graduate school of Baruch College. Perry Kaufman is the author of several popular trading books including A Short Course in Technical Trading and Alpha Trading.

Mr. Kaufman can be contacted through his website perrykaufman.com.

Preface to the Fifth Edition xv

Chapter 1 Introduction 1

The Expanding Role of Technical Analysis 1

Convergence of Trading Styles in Stocks and Futures 2

A Line in the Sand between Fundamentals and Technical Analysis 4

Professional and Amateur 5

Random Walk 6

Deciding on a Trading Style 8

Measuring Noise 10

Maturing Markets and Globalization 14

Background Material 16

Research Guidelines 18

Objectives of This Book 19

Profile of a Trading System 20

A Word about the Notation Used in This Book 23

And Finally . . . 23

Chapter 2 Basic Concepts and Calculations 25

About Data and Averaging 26

On Average 30

Price Distribution 33

Moments of the Distribution: Variance, Skewness, and Kurtosis 37

Standardizing Risk and Return 48

The Index 54

Standard Measurements of Performance 58

Probability 59

Supply and Demand 66

Chapter 3 Charting 79

Finding Consistent Patterns 80

What Causes the Major Price Moves and Trends? 82

The Bar Chart and Its Interpretation by Charles Dow 83

Chart Formations 92

Trendlines 94

One-Day Patterns 102

Continuation Patterns 113

Basic Concepts in Chart Trading 117

Accumulation and Distribution—Bottoms and Tops 118

Episodic Patterns 132

Price Objectives for Bar Charting 133

Implied Strategies in Candlestick Charts 139

Practical Use of the Bar Chart 144

Evolution in Price Patterns 148

Chapter 4 Charting Systems and Techniques 151

Dunnigan and the Thrust Method 152

Nofri’s Congestion-Phase System 155

Outside Days with an Outside Close 157

Inside Days 158

Pivot Points 158

Action and Reaction 159

Channel Breakout 167

Moving Channels 170

Commodity Channel Index 171

Wyckoff’s Combined Techniques 172

Complex Patterns 173

A Study of Charting Patterns 176

Bulkowski’s Chart Pattern Rankings 178

Chapter 5 Event-Driven Trends 181

Swing Trading 182

Constructing a Swing Chart Using a Swing Filter 184

Point-and-Figure Charting 195

The N-Day Breakout 222

Chapter 6 Regression Analysis 235

Components of a Time Series 235

Characteristics of the Price Data 236

Linear Regression 238

Linear Correlation 248

Nonlinear Approximations for Two Variables 252

Transforming Nonlinear to Linear 256

Evaluation of Two-Variable Techniques 257

Multivariate Approximations 259

ARIMA 267

Basic Trading Signals Using a Linear Regression Model 273

Measuring Market Strength 276

Chapter 7 Time-Based Trend Calculations 279

Forecasting and Following 279

Price Change over Time 284

The Moving Average 284

Geometric Moving Average 292

Accumulative Average 293

Reset Accumulative Average 293

Drop-Off Effect 293

Exponential Smoothing 293

Plotting Lags and Leads 307

Chapter 8 Trend Systems 309

Why Trend Systems Work 309

Basic Buy and Sell Signals 314

Bands and Channels 320

Applications of a Single Trend 330

Comparison of Major Trend Systems 336

Techniques Using Two Trendlines 350

Multiple Trends and Common Sense 356

Comprehensive Studies 359

Selecting the Right Trend Method and Speed 359

Moving Average Sequences: Signal Progression 363

Early Exits from a Trend 366

Moving Average Projected Crossovers 366

Chapter 9 Momentum and Oscillators 369

Momentum 370

Divergence Index 384

Oscillators 385

Double-Smoothed Momentum 404

Velocity and Acceleration 412

Hybrid Momentum Techniques 416

Momentum Divergence 418

Some Final Comments on Momentum 426

Chapter 10 Seasonality and Calendar Patterns 427

A Consistent Factor 428

The Seasonal Pattern 429

Popular Methods for Calculating Seasonality 430

Seasonal Filters 456

Seasonality and the Stock Market 478

Common Sense and Seasonality 483

Chapter 11 Cycle Analysis 485

Cycle Basics 485

Uncovering the Cycle 494

Maximum Entropy 514

Cycle Channel Index 520

Short Cycle Indicator 521

Phasing 523

Chapter 12 Volume, Open Interest, and Breadth 527

A Special Case for Futures Volume 527

Variations from the Normal Patterns 529

Standard Interpretation 531

Volume Indicators 535

Breadth Indicators 546

Interpreting Volume and Breadth Systematically 554

An Integrated Probability Model 558

Intraday Volume Patterns 559

Filtering Low Volume 562

Market Facilitation Index 564

Chapter 13 Spreads and Arbitrage 565

Dynamics of Futures Intramarket Spreads 566

Carrying Charges 567

Spreads in Stocks 569

Spread and Arbitrage Relationships 570

Risk Reduction in Spreads 571

Arbitrage 572

The Carry Trade 596

Changing Spread Relationships 600

Intermarket Spreads 602

Chapter 14 Behavioral Techniques 617

Measuring the News 618

Event Trading 623

Commitment of Traders Report 635

Opinion and Contrary Opinion 641

Fibonacci and Human Behavior 648

Elliott’s Wave Principle 651

Price Target Constructions Using the Fibonacci Ratio 660

Fischer’s Golden Section Compass System 662

W. D. Gann—Time and Space 666

Financial Astrology 671

Chapter 15 Pattern Recognition 685

Projecting Daily Highs and Lows 687

Time of Day 689

Opening Gaps 699

Weekday, Weekend, and Reversal Patterns 711

Computer-Based Pattern Recognition 732

Artificial Intelligence Methods 735

Chapter 16 Day Trading 737

Impact of Transaction Costs 738

Key Elements of Day Trading 744

Trading Using Price Patterns 753

Intraday Breakout Systems 759

Intraday Volume Patterns 774

Intraday Price Shocks 775

Chapter 17 Adaptive Techniques 779

Adaptive Trend Calculations 779

Adaptive Variations 788

Other Adaptive Momentum Calculations 793

Adaptive Intraday Breakout System 796

An Adaptive Process 797

Considering Adaptive Methods 798

Chapter 18 Price Distribution Systems 801

Measuring Distribution 801

Use of Price Distributions and Patterns to Anticipate Moves 805

Distribution of Prices 811

Steidlmayer’s Market Profile 822

Using Daily Distributions to Identify Support and Resistance 830

Chapter 19 Multiple Time Frames 833

Tuning Two Time Frames to Work Together 833

Elder’s Triple-Screen Trading System 835

Robert Krausz’s Multiple Time Frames 838

Martin Pring’s KST System 842

Chapter 20 Advanced Techniques 845

Measuring Volatility 845

Using Volatility for Trading 856

Trade Selection Using Volatility 861

Liquidity 867

Trends and Price Noise 868

Trends and Interest Rate Carry 871

Expert Systems 871

Fuzzy Logic 875

Fractals, Chaos, and Entropy 880

Neural Networks 886

Genetic Algorithms 895

Replication of Hedge Funds 902

Chapter 21 System Testing 905

Expectations 907

Identifying the Parameters 908

Selecting the Test Data 910

Testing Integrity 916

Searching for the Best Result 919

Visualizing and Interpreting Test Results 922

Large-Scale Testing 932

Refining the Strategy Rules 937

Arriving at Valid Test Results 938

Comparing the Results of Two Systems 946

Profiting from the Worst Results 950

Retesting for Changing Parameters 951

Testing across a Wide Range of Markets 954

Price Shocks 970

Anatomy of an Optimization 972

Summarizing Robustness 976

Chapter 22 Practical Considerations 983

Use and Abuse of the Computer 984

Extreme Events 992

Gambling Techniques—The Theory of Runs 1000

Selective Trading 1011

System Trade-Offs 1012

Trading Limits and Disconnected Markets 1018

Silver and NASDAQ—Too Good to Be True 1020

Similarity of Systematic Trading Signals 1021

Chapter 23 Risk Control 1027

Mistaking Luck for Skill 1027

Risk Aversion 1028

Liquidity 1033

Measuring Return and Risk 1034

Leverage 1046

Leverage Based on Exposure 1049

Individual Trade Risk 1050

Kaufman on Stops and Profit-Taking 1059

Ranking of Markets for Selection 1062

Probability of Success and Ruin 1072

Entering a Position 1076

Compounding a Position 1080

Equity Trends 1085

Investing and Reinvesting: Optimal f 1088

Comparing Expected and Actual Results 1092

Chapter 24 Diversification and Portfolio Allocation 1099

Diversification 1100

Changing Correlations 1105

Types of Portfolio Models 1105

Classic Portfolio Allocation Calculations 1107

Finding Optimal Portfolio Allocation Using Excel’s Solver 1109

Kaufman’s Genetic Algorithm Solution to Portfolio Allocation (GASP) 1114

Volatility Stabilization 1142

Appendix 1 Statistical Tables 1147

Appendix 2 Matrix Solution to Linear Equations and Markov Chains 1151

Appendix 3 Trigonometric Regression for Finding Cycles 1161

Bibliography 1175

About the Companion Website 1191

Index 1193