Trading System Design: A Statistical Approach by John F. Ehlers and Ric Way
Judging By The Numbers
Here’s how to start with the basics and determine if an identifiable event has a statistical edge in predicting future prices—before you even start to build a trading system.
Many trading systems begin with indicators, and because of that, the question you should be asking is, “What do indicators indicate?” The correct answer is that most of the time, they don’t indicate much. Indicators are just specialized filters.
Some indicators, like the commodity channel index (CCI), relative strength index (RSI), and stochastic, are basically first-order high-pass filters that remove the longer wave components of the prices and display them as oscillators. Other indicators, like moving averages, are basically smoothing filters that remove the high-frequency components and aliasing noise. Of course, there are combinations of the two kinds of filters. The basic question still remains whether shaping the price data by filtering has any predictive power regarding future prices.