V.11:10 (410-414): Designing Trading Systems For The Stock Market by Roger Altman, Ph.D.

Designing Trading Systems For The Stock Market by Roger Altman, Ph.D.

System designers are aware that the traditional methods used to select parameter values are prone to overfitting. What, then, can be done about it? Stocks & Commodities Roger Altman presents a method to reduce this problem by using randomized data to produce parameter values for trading systems that have the best chance of duplicating real-time results.

Mechanical trading systems attempt to exploit the non random portion of price fluctuations. Generally speaking, such trading methods have two parts: the setup and the trigger. The setup usually refers to an indicator that can predict price direction in the longer time span, whereas the trigger has predictive value in the near term. Good system development requires that these two indicators work independently of one another and complement each other's predictive power. This requirement implies that the same price change cannot be used for both setup and trigger indicators because then their separate predictive abilities would be lost.

SETUP AND TRIGGER INDICATORS

The most practical way to ensure independent forecasting capacity is to formulate setup and trigger indicators from unrelated sources of raw data. Because the system developer should be aware that the response from a trigger indicator should be as fast as possible to limit drawdown, calculations based on recent price change should usually be relied on to provide short-term market predictions.

Having taken into account short-term price fluctuations for the trigger indicator, the system developer must find unrelated data to determine when the stock market is set up to rise or fall in the longer timeframe. Sources for this information come from four general areas: interest rate changes (especially Federal Reserve policy changes), sentiment (always be a contrarian at bullish or bearish extremes), commercial, versus public open interest activity (follow the smart money) and broad-based market momentum in the longer timeframe (that is, select a trigger that relies on daily price changes of a narrow index such as the Dow Jones Industrial Average [DJIA], and for the setup use weekly values of a broad-based index such as the Value Line index).

While interest rate policy changes at the Federal Reserve Board are the single most reliable indicator of longer-term market direction, such changes are not frequent enough to serve as a practical setup indicator. Similarly, sentiment extremes — which produce the most reliable forecasts of market direction — do not occur often enough to satisfy the requirements of an active trading system. On the other hand, combining signals from weekly stock market momentum and commercial versus public open interest levels through the Commitment of Traders Report provide a sufficient number of setup signals.