A Guide to Creating A Successful Algorithmic Trading Strategy

Turn insight into profit with guru guidance toward successful algorithmic trading

A Guide to Creating a Successful Algorithmic Trading Strategy provides the latest strategies from an industry guru to show you how to build your own system from the ground up. If you're looking to develop a successful career in algorithmic trading, this book has you covered from idea to execution as you learn to develop a trader's insight and turn it into profitable strategy. You'll discover your trading personality and use it as a jumping-off point to create the ideal algo system that works the way you work, so you can achieve your goals faster. Coverage includes learning to recognize opportunities and identify a sound premise, and detailed discussion on seasonal patterns, interest rate-based trends, volatility, weekly and monthly patterns, the 3-day cycle, and much more—with an emphasis on trading as the best teacher. By actually making trades, you concentrate your attention on the market, absorb the effects on your money, and quickly resolve problems that impact profits.

Algorithmic trading began as a "ridiculous" concept in the 1970s, then became an "unfair advantage" as it evolved into the lynchpin of a successful trading strategy. This book gives you the background you need to effectively reap the benefits of this important trading method.

• Navigate confusing markets
• Find the right trades and make them
• Build a successful algo trading system
• Turn insights into profitable strategies

Algorithmic trading strategies are everywhere, but they're not all equally valuable. It's far too easy to fall for something that worked brilliantly in the past, but with little hope of working in the future. A Guide to Creating a Successful Algorithmic Trading Strategy shows you how to choose the best, leave the rest, and make more money from your trades.

Acknowledgments xi

Chapter 1 A Brief Introduction: The Ground Rules 1

My Objective 2

The Ground Rules 3

The Process 3

Basic Trading Systems 6

Chapter 2 The Idea 9

Begin at the Beginning 9

The Idea Must Match Your Trading Personality 11

I Need a Fast Payout 12

Withstanding the Test of Time 13

Chapter 3 Don’t Make It Complex 15

A Word about Noise 17

Integrated Solutions versus Building Blocks 18

More Rules, Fewer Opportunities, Less Success 19

Chapter 4 Why Should I Care about “Robust”

If I’m Trading Only Apple? 21

Is It Robust? 22

Another Dimension 25

But Which Parameter Value Do I Trade? 27

Multiple Time Frames 28

Is One Trend Method Better Than Another? 29

Chapter 5 Less is More 33

Volatility Cuts Both Ways 34

Bull Markets Happen When Everyone is in Denial 36

Chapter 6 If You’re a Trend Follower, Don’t Use Profit-Taking or Stops 39

The Dynamics of a Trend Strategy 42

It’s Getting Harder to Find the Trend 42

The Eurodollar Trend 43

Where Do You Place Your Stop? 45

What about Profit-Taking? 46

Entering on a Pullback 47

Which is the Best Trend-Following Method? 48

Chapter 7 Take Your Profit If You’re a Short-Term Trader 51

What’s Bad for the Trend is Good for the Short-Term Trader 53

If You Can’t Use Stops for Trend Following, Can You Use Them for Short-Term Trading? 55

There Are Always Exceptions 56

Chapter 8 Searching for the Perfect System 59

Looking at the Results 61

How Much Data and How Many Trades Are Enough? 62

So, Which Parameter Value Do I Pick? 63

Chapter 9 Equal Opportunity Trading 65

Calculating Position Size 66

Avoid Low-Priced Stocks 66

True Volatility-Adjusting Doesn’t Work for a Portfolio of Stocks 67

Risk in Futures 67

Target Risk 68

Calculate the Rate of Return for the Portfolio 69

Assigning Risk to Your Portfolio 72

Multiple Strategies Are More Important 73

Not So Easy for the Institutions 75

Too Much of a Good Thing Can Be Bad 75

Chapter 10 Testing—The Fork in the Road 79

Let the Computer Solve It for You 81

How Do You Evaluate the Results? 83

What’s Feedback? 84

Hidden Danger 86

Forgotten History 86

Use True Costs 87

Use Dirty Data 89

Back-Adjusted and Split-Adjusted Data 91

The Different Performance Measures 92

Interpreting the Ratio 92

Not Everyone Uses the Information Ratio 93

Number of Trades 94

Expectations 94

Chapter 11 Beating It into Submission 97

Fixing Losing Periods 97

Use the Average Results 99

Squeezing the Life Out of a System 101

Generalizing the Rules 105

Chapter 12 More on Futures 107

Leverage 108

Conversion Factors for Calculating Returns 109

Don’t Forget FX 110

FX Quotes 111

Real Diversification 113

The Life Cycle of a Commodity Market 115

Chapter 13 I Don’t Want No Stinkin’ Risk 117

A Clear Plan 119

Avoid Low-Priced Stocks 120

Volatility Over 100%? 121

Don’t Trade When Volatility is Very High 122

Sidestepping Price Shocks 122

Portfolio Drawdown 123

Business Risk 124

Gearing Back Up 125

Chapter 14 Picking the Best Stocks (and Futures Markets)

for Your Portfolio 127

Asking Too Much 127

The Practical Solution 128

Ranking Success 130

Rotation 132

Chapter 15 Matching the Strategy to the Market 133

Noise for Stocks 134

Noise for ETFs 136

Noise for Futures 136

Chapter 16 Constructing a Trend Strategy 139

The Trend 140

Buying and Selling Rules 141

First Tests 141

Costs 143

Expectations 143

Satisfying the First Milestone 144

Profit-Taking 146

Volatility Filter 148

Combining Rules 149

Multiple Entries and Exits 150

More Markets, More Robustness 151

Stabilizing the Risk 152

Do It Yourself 153

Chapter 17 Constructing an Intraday Trading Strategy 155

The Time Frame 156

Outline 157

Deciding on the Strategy 158

Choosing a Strategy 158

Directional or Mean Reverting 159

The Basic Rules 160

The Breakout Rule 161

Profit Taking and Extreme Volatility 162

What About the Trend? 163

Chapter 18 Summary 167

Resources 169

System Development Platforms 169

Blogs 170

Periodicals 171

Perry Kaufman Websites 172

Index 173

PERRY J. KAUFMAN is a leading investment consultant with more than forty years of experience in the equity and derivatives markets. He is the author of twelve trading books, including Trading Systems and Methods, Fifth Edition; A Short Course in Technical Trading; Smarter Trading; and Global Equity Investing. Perry continues to be a pioneer in the use of computer models for making financial decisions.

THE NO-FRILLS APPROACH TO BUILDING SUCCESSFUL ALGORITHMIC TRADING SYSTEMS

When Perry Kaufman started creating automated systems to trade in the early 1970s, the very idea was demeaned by professional traders as “ridiculous.” Now, high-frequency trading is attacked for its unfair advantage that “steals money from the ordinary investor.” In A Guide to Creating a Successful Algorithmic Trading Strategy, Perry puts the power in your hands by pulling back the curtain on algorithmic trading.

Whether you’re a professional trader or money manager looking to perfect your own automated trading system or an individual investor who wants financial control with today’s technological advantages, this compact guide gives you a sophisticated approach to building successful algo trading systems in a user-friendly, how-to format. More than merely a step-by-step book to backtesting, this expert guide culls the author’s vast experience over forty years, through all types of markets, to illustrate why achieving success in trading is not about buying and selling at a profit, but fully hinges on developing the right trades and then managing their risk. The proven guidelines inside for building a reliable trading system from the ground up give you the necessary theory and historical perspective to develop your system with confidence and the technical know-how to fine-tune it to your specific parameters and risk. Keep the expertise sought after the world over at your fingertips to:

• Include the right depth of rules in your algorithms
• Avoid common traps at each step of development and testing
• Know exactly when your algo system is ready to stop paper trading and make real profits

A cornerstone principle of this succinct guidebook is simplicity, and from the underlying trading best practices to designing the systems themselves, a straightforward approach is preferred and proven to win the day. Many algorithmic systems fail when they are finally launched into the market, but A Guide to Creating a Successful Algorithmic Trading Strategy will show you the pitfalls and process for greatly improving your ability to succeed. Once you’ve read this book you’ll want to reread it again and again until you’ve made it part of your own way of working.

From developing insights as a trader and turning those insights into profitable strategies all the way to the critical realities of trading for a living—this masterpiece guide boils down more than four decades of high-level experience into a clear framework that lets you compete with the experts.