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Trend Analysis
How System Trading Works
Known sometimes as mechanical trading, system trading is the practice of placing transactions in various types of sharemarkets based on a set of rules. The underlying premise is that by adhering to properly chosen rules for buying and selling, a trader can generate regular profits without the need for any ad hoc decision making. Certain rule based systems have fared remarkably well over the course of time. Three examples are listed below.
Channel Breakout System
This system consists of only two rules:
- When the price moves higher than the highest high in the previous N days, close all short positions and enter a long position.
- When the price moves lower than the lowest low in the previous N days, close all long positions and enter a short position.
Moving Average Crossover System
This system is slightly more complex. The term moving average here can be taken to mean either a simple moving average (SMA) or an exponential moving average (EMA). This system requires that a short term (M days) and long term (N days) moving average be tracked daily. Again, there are only two rules:
- When the M day moving average moves higher than the N day moving average, close all short positions and enter a long position.
- When the M day moving average moves lower than the N day moving average, close all long positions and enter a short position.
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Moving Average Calculations
N day SMA = (Sum of all prices over the last N days) / N
N day EMA = [(Yesterday's EMA * [N - 1]) + Yesterday's price] / N
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Volatility Breakout System
This is really a class of similar systems known by a variety of names. In order to trade this system, it is necessary to calculate two values, the N day moving average and a volatility measure. The N day moving average plus the volatility measure is referred to as the upper band and the N day moving average minus the volatility measure is referred to as the lower band for the system. Any of the volatility measures to the right may be used for this system. This time, there are three trading rules:
- If the price moves above the upper band, enter a long position.
- If the price moves below the lower band, enter a short position.
- If the price moves between the bands, exit all positions.
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Volatility Calculations
Standard deviation: Take the SMA over the last N days. For each of the last N days, find the variance which is (price - SMA) * (price - SMA). Take the sum of each of these variances and divide by N. The square root of this sum is the standard deviation.
Rate of Change: A moving average of the difference between yesterday's closing price and the closing price on the day prior.
Average True Range: A 14 day EMA of the true range, which is the largest of close to close change, today's high - yesterday's close, or yesterday's close - today's low.
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Parameter Values
In each of the systems above, letters have been used to designate certain values. For real world trading some numbers must serve as M and N. These chosen values are referred to as parameters of the trading system and they often have a huge effect on the returns the system produces. To understand the effect that this can have on trading activities, see our article on robustness.
Market Modeling
In addition to the issue of proper parameter selection, the three mechanical systems here (as well as most others) are the product of methods which treat backtesting as the primary means of determining the value of different trading rules. Backtesting is fine as a tool, but to develop a system based solely on backtesting without a solid underlying model is the trader's equivalent of poking about at a piano until a few notes sound good in sequence rather than learning about the structure of music and then producing a crafted composition. At iSigma, our approach is every bit as systematic as those just described above but it is also based on a coherent model of price movement in markets, rather than a trial and error development process.
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All material on this site is property of iSigma. Trading is risky business and should not be engaged in without first consulting with a qualified financial advisor. System signals are presented on an "as is" basis with no implied suitability for any particular purpose. All trading decisions made after consideration of the material here are ultimately the responsibility of the trader. Hypothetical or simulated performance results that appear on this web site have certain limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under, or over compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs, in general, are also subject to the fact that they are designed with the benefit of hindsight. Past profits are not necessarily an indicator of future results, and no representation is being made that any account will or is likely to achieve profits or losses similar to those shown. Nothing on this site constitutes a solicitation to buy or an offer to sell or buy any tradable instrument.
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