Automated Trading – Software Analysis and Back Testing

In addition to demonstrating the power of automated trading , we will discuss the logic behind the systems which have been rated #1 or #2 for all of 1999. This session will examine in detail the methodology used to first develop, and then test, the theories which have been used to create the top rated automated trading systems worldwide.

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Automated Trading Defined

The field of automated trading and technical analysis is fairly new to the realm of the stock trader.

Prior to the recent advances in price delivery and analysis, most stock trading decisions were made on fundamental information, herd mentality, and the reliance on professional analysts who would give a "strong buy", "Hold", "Sell" or other recommendation after a careful study of the company and its chances of being profitable in the near future.

While these parameters are still important in today’s trading environment, the advent of automated trading can give the trader a definite edge in his / her trading strategy development.

With internet technology evolving at a blinding pace, technical analysis tools are more available to the stock trader today than ever before. There are a multitude of web sites which offer intraday and daily price quotes and charts either free or for a modest subscription fee. Some of the sites also offer proprietary chart analysis tools for a subscription fee. One can only surmise what may be available for use by the trader in even the near future.

The basic theory used by those who develop their trading plans using technical analysis is simply this: All fundamental information, be it the price of the stock, the earnings of the company, management changes, government reports, fed adjustments in the prevailing interest rate, etc. are all eventually reflected in the price of the stock in question. With that basic fact In mind, why pay attention to anything but price?

Historically, Patterns will Repeat Themselves

Given the fact that the price of a stock is an ultimate reflection of the fundamental state of the company, one can carefully study price patterns which develop as time moves forward, on a daily basis and even on an intraday price chart.

Historically, events tend to repeat themselves. Learning from past occurrences and the subsequent reaction of price to these occurrences is the basis of technical analysis.

Certain price patterns have a significant tendency to repeat themselves on a regular basis. Astute study of these patterns over an adequate amount of past data can reveal situations which are statistically significant in their tendency to be repetitive in nature. Tables which display the repeatability of the popular chart patterns can be easily located in the popular literature on technical analysis.

Another reason technical analysis is effective, and this one may be a bit hard to swallow at first, is that because so many people use it. In this respect, if a large number of traders are convinced that a stock will rise because its 21 day moving average has turned up, the price would rise in response to the influx of buyers entering the market due to this fact alone. In a sense this can become a self fulfilling prophecy - the more it is used the better it works. Swallow hard.

Two of these repetitive patterns, daily price follow through and intraday range expansion, form the nucleus of most of my system development efforts. A detailed discussion of these relatively simple patterns follow.

Follow Through

Follow through can best be described as a tendency of a market, when in a short term trend, to stay in the trend into the next day of trading. A market which has a weak close is expected to follow through to the downside at least for part of the next day; a market exhibiting a stronger close should show some strength early tomorrow.

For our purposes, we'll define the strength or weakness of a daily trend by the relative position of the close with respect to the high and the low of the day. If the close is relatively near the high of the day the market is exhibiting a strong close - one which should follow through to the upside in early trading for the next day. If the close is nearer the lowest price of that market for the day, it is defined to be a weak close which should lead to lower prices during at least the early part of the trade tomorrow.

Range Expansion

Think about the first few minutes of trade posted for the day. What is the likelihood of this range being the range for the entire day? I think you would agree that it is reasonably small. Since we are fairly certain that the range will expand from this point, it would be extremely helpful if we were able to determine, with some degree of certainty, on which side of the early range this expansion was most likely to occur.

The trick comes in predicting the eventual breakout of the early price range. We can use price patterns from both daily and intraday data for this purpose.

Obviously, the tendencies uncovered by the follow-through technique above can be used as one major item to consider when determining the direction of the eventual breakout from the early range of the day. Important also is the relationship between the range of the opening few minutes of the day and the range which has developed during the first 45 - 90 minutes of trading, the actual time period varying with the volatility of the issue in question. The aggregate activity of the market during this period, both in size and its position relative to the first few minutes of trade, can give a good hint as to the eventual movement of the market for the remainder of the day. Finally, it can be equally important to compare the advancing and declining issues and volume of advancing and declining issues from the New York Stock Exchange to each other to assess general market direction. If the advance - decline lines are substantially out of balance, one way or the other, the market can be expected to move in the direction of the bias.

Using the above analyses, one can be relatively certain of the direction of the eventual range expansion breakout.

The point to be made is as follows.

A successful system can be traded using all of the above market factors. However, to manually calculate and / or observe all of the above information on several stock issues at relatively the same time in the market day would challenge even the most astute mathematician / scholar.

Here is where the automated system approach has its application.

A properly designed system can easily make all of the calculations on as many issues as one cares to follow almost instantaneously, thereby relieving the trader of the laborious, error prone number crunching and free him / her to further analyze the outputs of the system reports.

Most traders will be reluctant to allow the system to call all the shots, and rightly so. There is absolutely no substitute for the human mind when it comes to complex decision making.

Obviously, the entire trading decision will not be made using only these reports, but this part of the formula can be most certainly accessed with a minimum of effort using an automated trading system.

The table below illustrates how a system developed using the above observations would have performed during a selected period.

Conclusions

Although technical analysis / automated system trading has not been a major factor in the trading of stock issues in the past, the advances in technology available for the analysis of today’s market have made significant changes in the amount and type of information available to today’s trader.

While most if not all trading decisions will be made with several inputs at the disposal of the trader, the use of an automated trading system can significantly reduce the effort required and increase the accuracy of the myriad of calculations necessary to formulate a winning trading plan.

Not only is efficiency enhanced, the confidence level of the trader is also buoyed by the realization that the system has worked well in the past as evidenced by system and optimization reports.

Contact Information:

Dr. John F. Clayburg

29568 Hwy 141

Coon Rapids, Iowa 50058-7178

5239. Voice and FAX

e mail: clayburg@pionet.net

Web Site: http://www.clayburg.com