Beyond Technical Analysis Beyond Technical Analysis: How to Develop and Implement a Winning Trading System Tushar S Chande, PhD John Wiley 61 Sons, Inc New York • Chichester • Brisbane • Toronto • Singapore • Weinheim This text is printed on acid-free paper Copyright © 1997 by Tushar S Chande Published by John Wiley & Sons, Inc Data Scrambling is a trademark of Tushar S Chande TradeStadon, System Writer Plus, and Power Editor are trademarks of Omega Research, Inc Excel is a registered trademark of Microsoft Corporation Continuous Contractor is a trademark of TechTools, Inc Portfolio Analyzer is a trademark of Tom Berry All rights reserved Printed simultaneously in Canada Reproduction or translation of any part of this work beyond that permitted by Section 107 or 108 of the 1976 United States Copyright Act without the permission of the copyright holder is unlawful Requests for permission or further information should be addressed to the Permissions Department of John Wiley & Sons This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services If legal advice or other expert assistance is required, the services of a competent professional person should be sought Library of Congress Cataloging in Publicaton Data: Chande, Tushar S., 1958Beyond technical analysis : how to develop & implement a winning trading system / Tushar S Chande Includes index ISBN 0-471-16188-8 (cloth : alk paper) Investment analysis I Tide II Series HG4529.C488 1997 332.6 —dc20 96-34436 Printed in the United States of America 10 98765432 Contents Preface xi Acknowledgments xiii Developing and Implementing Trading Systems Introduction The Usual Disclaimer What Is a Trading System? Comparison: Discretionary versus Mechanical System Trader Why Should You Use a Trading System? Robust Trading Systems: TOPS COLA How Do You Implement a Trading System? Who Wins? Who Loses? Beyond Technical Analysis Principles of Trading System Design Introduction 11 What Are Your Trading Beliefs? 12 Six Cardinal Rules 14 Rule 1: Positive Expectation 15 Rule 2: A Small Number of Rules 17 11 viii Contents Rule 3: Robust Trading Rules 22 Rule 4: Trading Multiple Contracts 29 Rule 5: Risk Control, Money Management, and Portfolio Design 32 Rule 6: Fully Mechanical System 36 Summary 37 Foundations of System Design 39 Introduction 39 Diagnosing Market Trends 40 To Follow the Trend or Not? 44 To Optimize or Not to Optimize? 48 Initial Stop: Solution or Problem? 52 Does Your Design Control Risks? 60 Data! Handle with Care! 64 Choosing Orders for Entries and Exits 66 Understanding Summary of Test Results 67 What the Performance Summary Does Not Show 70 A Reality Check 71 Developing New Trading Systems 73 Introduction 73 The Assumptions behind TrendFollowing Systems 74 The 65sma-3cc Trend-Following System 75 Effect of Initial Money Management Stop 88 Adding Filter to the 65sma-3cc System 93 Adding Exit Rules to the 65sma3cc System 99 Channel Breakout-Pull Back Pattern 101 An ADX Burst Trend-Seeking System 111 A Trend-Antitrend Trading System 116 Gold-Bond Intermarket System 123 A Pattern for Bottom-Fishing 132 Contents ix Identifying Extraordinary Opportunities 140 Summary 144 Developing Trading System Variations 147 Introduction 147 Channel Breakout on Close with Trailing Stops 149 Channel Breakout on Close with Volatility Exit 152 Channel Breakout with 20-Tick Barrier 155 Channel Breakout System with Inside Volatility Barrier 159 Statistical Significance of Channel Breakout Variations 161 Two ADX Variations 165 The Pullback System 168 The Long Bomb — A Pattern-based System 173 Summary 177 Equity Curve Analysis 179 Introduction 179 Measuring the "Smoothness" of the Equity Curve 180 Effect of Exits and Portfolio Strategies on Equity Curves 186 Analysis of Monthly Equity Changes 194 Effect of Filtering on the Equity Curve 200 Summary 204 Ideas for Money Management Introduction 207 207 The Risk of Ruin 208 Interaction: System Design and Money Management 212 Projecting Drawdowns 218 Changing Bet Size after Winning or Losing 221 Summary 224 x Contents Data Scrambling 227 Introduction 227 What You Really Want to Know about Your System 227 Past Is Prolog: Sampling with Replacement 229 Data Scrambling: All the Synthetic Data You'll Ever Need 231 Testing a Volatility System on Synthetic Data 236 Summary 239 A System for Trading 241 Introduction 241 The Problem with Testing 242 Paper Trading: Pros and Cons 242 Do You Believe in Your System? 243 Time Is Your Ally 244 No Exceptions 245 Full Traceability 245 "Guaranteed" Entry into Major Trends 246 Starting Up 247 Risk Control 248 Do You Have a Plan? 248 How Will You Monitor Compliance? 249 Get It Off Your Chest! 249 Focus on Your Trading 250 Trading with Your Head and Heart 250 Summary 252 Selected Bibliography 255 About the Disk 253 Index 261 Preface This is a book about designing, testing, and implementing trading systems for the futures and equities markets The book begins by developing trading systems and ends by defining a system for trading It focuses exclusively on trading systems Hence, I have assumed that the reader has at least a working knowledge of technical analysis and is familiar with software for developing technical trading systems The book is broadly divided into two parts The first half deals with development and testing—how the system worked on past data— and discusses basic rules, key issues, and many new systems The second half explores how the system might in the future, with a focus on equity curves, risk control, and money management A key contribution is a new method called "data scrambling," which allows unlimited amounts of synthetic data to be generated for true out-ofsample testing The last chapter brings all of the material together by offering solutions to practical problems encountered in implementing a trading system This book goes beyond technical analysis—it bridges the gap between analysis and trading It provides a comprehensive treatment of trading systems, and offers a stimulating mix of new ideas, timeless principles, and practical guidelines to help you develop trading systems that work Acknowledgments I thank Nelson F Freeburg for twice reading this manuscript Nelson's meticulous attention to detail, outstanding grasp of the subject, sharp eye for inconsistencies, and love of the language have helped to improve this book immeasurably Nelson edits a monthly newsletter, Formula Research, which is "must-reading" for serious students of the financial markets A good editor is essential to guide a book to completion I want to thank Pamela Van Giessen of John Wiley & Sons for being the accessible, cheerful, and resourceful editor every author loves Beyond Technical Analysis ... moving-average systems a No,l Disagree a a a a a a a a a a a a a a a a a a a a a D a a a a 14 Principles of Trading System Design Six Cardinal Rules Once you identify your strongly held trading. .. markets trade a like to use only my own analysis of price action a like to use daily data in my analysis a like to use intraday data in my analysis a like to use weekly data in my analysis a. .. on implementing the trade plan as accurately and consistently as possible Thus, you must go beyond technical analysis, deep into trade management and organized trading, to win Beyond Technical