Perry J. Kaufman - A Guide to Creating a Successful Algorithmic Trading Strategy

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Copyright 2016 by Perry J Kaufman. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.

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ISBN 978-1-119-22474-7 (Hardcover)
ISBN 978-1-119-22476-1 (ePDF)
ISBN 978-1-11-9-22475-4 (ePub)

My special thanks to three people with incredible knowledge in this area, and who could have easily written this themselves, John Kowalik, John Ehlers, and Linda Raschke. They generously provided very extensive and insightful comments that resulted in numerous changes and hopefully, considerably more clarity. My appreciation also goes to Mark Rzepczynski, who tenaciously questioned some of my conclusions and to Ernie Varitimos and Murray Ruggiero for their insight.

To my mother, Helen, who has proofread every book that Ive written. If you find any errors, please direct your comments to her.

Thank you all.

PJK

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A reminder from Barbara Rockefellers Morning Forex Briefing:

The researches of many commentators have already thrown much darkness on this subject, and it is probable that if they continue we shall soon know nothing at all.

Mark Twain

Everything should be made as simple as possible, but not simpler.

Albert Einstein

If you havent heard it, a classic example of trading experience is the difference between a statistician and a trader. You flip a coin 99 times and it comes up heads each time. You ask the statistician, What are the odds that it will come up heads next time? The statistician answers, 50:50. You ask the trader the same question and he answers, 100 percent. Surprised, you ask the trader, Why? He responds, Because it couldnt possibly be a fair coin. The odds of getting 99 heads in a row are too high to have happened by chance. Experience transforms theory into reality.

When I first started trading using automated systems in the early 1970s, the very idea was demeaned by professional traders as ridiculous, the market just doesnt work that way, you cant make money if you dont know the value of the stock. Now that opinion seems to have been turned upside down. High frequency trading, the algorithmic trading system on steroids, has an unfair advantage, its stealing money from the ordinary investor. Times have changed, but attitudes have not.

This is a no-frills book. Its short because it just deals with the most important issues of developing a successful trading system and because youre more likely to read it all. It is intended to be a painless lesson in reality, those critical steps that you learn over time, often by doing them wrong. For some, it will be a confirmation that youre getting it right, and for others it may be an Aha! moment. It would be more responsible, and more scientific, to verify each of my conclusions yourself. But, if youre like me, you readily accept ideas that are reasonable and seem right, and you choose to believe them. Ive been uncertain at times, but I rarely regret a decision that comes from common sense.

Each chapter contains, in my opinion, the best way to deal with the various aspects of creating a trading system. All of the steps are important, and doing them incorrectly will show up later in your trading account, perhaps too late. Its better to spend a little extra time up front to increase your chances of success later on.

Before we get immersed in the details, there are some important items to define and disclose.

First, we all have biases. They are often found in what we dont say rather than what we actually state. I see that when I watch the political commentary on television and also in the evening news. Everyone seems to have an agenda.

My own biases are toward fully automatic trading, which include all the good and bad of it. I also like macrotrend systems, stock and various other arbitrage, and some pattern recognition, among other methods that I cant remember right now. I dont like systems with a lot of rules and Im suspicious of systems that work on only one market. Im going to try to balance my examples to show short-term and long-term systems, but the reality is that there will probably be more about long-term trend following, which I believe is used by more traders, especially at the early stages when they are dangling their collective toes in the water.

The process of developing a trading strategy involves eight well-defined steps, shown in . These should be clear, except for the marks on the left that show Change rules and Failed. From the top down, the trading idea comes first, then you need to get all the data that will be used to validate your strategy. You must have a trading platform to test your idea, which could be as simple as Excel, or as sophisticated as TradeStation. You enter your rules using that platform.