Trading Global Marketsusing Technical Analysis

Andy Bowerwww.alchemetrics.org

Format

Technical Analysis• Data• Chart Patterns• Computers/Backtesting• Neural Nets/Genetic Algorithms

Essentials of Trading• Markets• Money• Brokers

Risks, Reward and Practicality• Risk/Reward• “Practical” system building

Lecture OneTechnical Analysis

Andy Bowerwww.alchemetrics.org

Technical Analysis

“The examination of historical marketprice movements in order to predictfuture price movements”

Tenets:• Current prices reflect all available information• Prices “trend”; they are not entirely random• (Some) historical patterns tend to reoccur

Fundamental Analysis

Fundamentals vs Technicals

Apple Computer AAPL 2003/4Apple Computer AAPL 2003/4

XX

Technical Analysis Methods

Chart PatternsIndicatorsComputer analysis

• Backtesting – pattern isolation• Automated pattern matching

Data: Bars

Bars• Open-High-Low-Close-Volume• Weekly, Daily, Minute

PetsmartPetsmart PETMPETM–– Daily OHLC BarsDaily OHLC Bars

PetsmartPetsmart PETMPETM–– Volume SpikesVolume Spikes

Data: Candlesticks

GapsGaps

Data: Timescales

WeeklyWeekly

15 minute15 minute

DailyDaily

Patterns: Support/Resistance

SupportSupport

ResistanceResistanceSupport ASupport A

Resistance BResistance B

SupportSupport

NasdaqNasdaq 100 ETF Daily100 ETF DailyResistanceResistance

Patterns: Trends and Channels

NasdaqNasdaq 100 ETF Daily100 ETF Daily

Patterns: Reversal

Double/Treble Tops• 1st Peak on high volume• Trough• 2nd Peak usually on

lower volume• Break support on

high volume• Completion (often)

height of peaksbelow support

Ford DailyFord Daily

Patterns: Reversal

Head and Shoulders• Prior uptrend• Left shoulder• Pullback to neck• Head Peak• Pullback to neckline• Right shoulder• Break of neckline

on high volume signalstrend reversal

Citrix DailyCitrix Daily

Markov Game

Computer Pattern Matching

Strategy• Isolate tradable patterns.. Then test

Backtesting• Evaluation of a trading strategy using historical price

data to measure performance.

Metrics• Equity Curve• Profit Factor, Sharpe Ratio• Drawdown• Avg Trade %

BacktestingEquity Curve

BacktestingPeriod Returns

BacktestingPerformance Report

BacktestingOptimization

Strategies may have parameters• Optimize to maximize profitability• Need to be wary of “curve fitting”

Split data into segments• Backtest & Optimize on some segments• Then forward test on remaining segments

Minimize number of variables

Neural Networks

Used to isolate “unknown” patterns

BackpropagationBackpropagationNeural NetNeural Net

Real NeuronsReal Neurons

Neural Networks

Used to isolate “unknown” patternsInputs

• Indicators/Other Networks

Outputs• Profit/Sharpe Ratio/etc

Network configuration• Optimize using Genetic Algorithms

Backtesting• Curve Fitting issues are very important

Genetic Algorithms

Parameter Optimization• Searching a large multi-dimensional space• Typically better at avoid local optima

Use for Optimizing• Indicator based systems• Neural Network topology

Backtesting• Curve fitting issues are very important

Reading

Technical Analysis of the Financial MarketsMurphy: New York Institute of Finance

StockCharts.comhttp://stockcharts.com/education/ChartAnalysis/

Further ReadingDow Theory

in Murphy

Lecture TwoEssentials of Trading

Andy Bowerwww.alchemetrics.org

Essentials of Trading

Why People Trade• Money

What People Trade• Market

Where People Trade• Exchanges

How People Trade• Brokers• Orders• Margin• Shorting• Strategies

Money: Why People Trade

Investments• Pension Funds• Insurance Funds• Trusts• Individuals

Borrowers• House Buyers• Companies• Students

Hedgers• Producers

Exchange wealth now forExchange wealth now for(more) wealth in the future(more) wealth in the future

Exchange wealth in the futureExchange wealth in the futurefor wealth (facilities) nowfor wealth (facilities) now

Unknown future risk reductionUnknown future risk reduction

Market: What People TradeSecurities

Stocks• Shares issued to raise capital now• Regular dividend (interest) payment• Redeemable by selling to other investors at

“market” price.

Exchange Traded Funds (ETFs)• Funds hold portfolios matching common indices• QQQQ, DIA, SPY (US funds)

Bonds• Bonds, Notes issued to raise capital now• Bought (usually) for face value• Regular coupon (interest) payment• At term redeemed (usually) at face value

Market: What People TradeDerivatives

Options• Call Option – A right to purchase an asset at a strike

price on or before the expiration date. Cost of optionis the premium.

• Put Option – A right to sell an asset at a strike priceon or before the expiration date. Cost of option is thepremium.

Futures• Futures Contract - agreement to purchase a

commodity (item) for delivery in the future.

Leverage• Derivatives yield an amplification of gain or loss.

Market: What People TradeCurrencies

Exchange Rates• Profit from single exchange rate changes

Arbitrage• Exploit discrepancies in 3 way markets• E.g. yen-euro, euro-dollar, dollar-yen

Market: Where People Trade

Exchanges• UK: LIFFE, LSE• US: Amex, NYSE, CME

OTC• Over-the-Counter• Brokers and dealers negotiate trades• NASDAQ is a price quotation system for OTC trades• L1:Market Makers/L2:Brokers/L3:Investors

ECNs• Electronic Communication Networks• US ECNs – Island, Instinet, Archipelago etc.

Brokers: How People Trade Traders

• Investors• Borrowers• Hedgers

Trading Services• Market Makers/Specialists

Cross outstanding tradesOtherwise “deal” from own inventory (25%)Set bid & ask prices and profit from spread

• Brokers Interface between traders and market makersProfit from commission charges for orders filled

Traders effectively buy “liquidity” from Trading Services

Brokers: How People Trade

Direct Access BrokerDirect Access Broker$0.005$0.005 –– $0.01 per share$0.01 per share

Route direct to dealerRoute direct to dealer

WebWeb--based Discount Brokerbased Discount Broker$10$10--$20 per trade$20 per trade

““AutomaticallyAutomatically”” routed to dealerrouted to dealerFull Service BrokerFull Service Broker$100$100--$200 per trade$200 per trade

Additional research servicesAdditional research services

Brokers: How People TradeSpread Betting

WebWeb--based Spread Bettingbased Spread BettingLarger Bid/Ask SpreadLarger Bid/Ask Spread

Not actually trading securitiesNot actually trading securitiesTAX FREETAX FREE

Bid/Ask Prices

• Bid PricePrice offered to buy your asseti.e. Price at which you can sell

• Ask PricePrice offered to sell you an asseti.e. Price at which you can buy

• Bid <= Ask

Orders Market Orders

• Buy (initially) at inside ask• Sell (initially) at inside bid• Usually immediate fill during market hours

Limit Orders• Buy or Sell at specified limit price

Stop Orders• Sell triggered when price falls below stop price• Converted to market order when triggered• Used to manage risk.

Stop Limit Orders• Sell at a limit price when price falls below stop price• May not fill in fast moving market

Orders: Examples

1. Buy 100 @ MarketSell 100 @ 32 LimitSell 100 @ 29 Stop

2. Buy 100 @ 30.81 LimitSell 100 @ 33 LimitSell 100 @ 30.15 Stop

3. Buy 150 @ 32.6 StopSell 150 @ 32.85 LimitSell 150 @ 30.02 Stop

Open=31.48Open=31.48

High=32.95High=32.95

Close=32.71Close=32.71

Low=30.15Low=30.15

Entry @ 31.48Entry @ 31.48Exit @ 32Exit @ 32

Entry @ 31.48Entry @ 31.48Exit @ 30.15Exit @ 30.15

Entry @ 32.6Entry @ 32.6Exit @ 32.85Exit @ 32.85

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Margin

Standard Margin (US equity)• Margin accounts can borrow 100% of the account size (2:1)• Use of margin provides leverage: extra risk – extra gain

Day Trader Margin (US equity)• Accounts marked as pattern day trading must have a

minimum $25,000 balance• Day Trader Margin accounts can borrow 400% of the

account size (4:1)

Margin Calls• Accounts that exceed margin receive a margin call• Some brokers liquidate positions directly

Short Selling

Margin accounts can sell short• Borrow security from dealer with the aim to

buy it back at a lower price.

Shorting Advantages• An “obvious” way to profit in a falling market• Shorting an ETF index fund profits when

general market is bearish

Shorting Disadvantages• Unlimited potential for loss• Dividends must be paid out• Up-tick rule

Shorting Orders

Market Orders• Sell Short (initially) at inside bid• Cover (initially) at inside ask

Limit Orders• Sell or Cover at specified limit price

Stop Orders• Cover triggered when price rise above stop price• Converted to market order when triggered

Stop Limit Orders• Cover at a limit price when price rise above stop price• May not fill in fast moving market

Trading Styles

Buy & Hold or Position Trading• Buy and hold for long periods (years)• Portfolios accrue profits from general market direction

(on avg. 11%APR since 1920)• Often used by investment managers

Swing Trading• Buy or sell short and hold for up to several weeks• Attempt to capture profits from the price swings• Main vehicle of Hedge Funds

Day Trading• Buy or sell short and close positions by end of day• Scalpers attempt to “scalp” profits from small price

movements using large position sizes.

Trading Styles: HedgingBuy or Sell a correlated instrument to manage downside risk.

Industrial/Agricultural Hedging• Sell future contract against commodity.• Insure against price falls after upfront investment.• Limits upside and downside.

Stock hedging with futures contracts• Sell futures contract against correlated index• Insure again overall market fall/crash• Limits upside and downside.

Stock hedging with options• Buy put option to sell at a minimum future price• Limits downside, preserves upside (for premium).

Options Leverage/HedgingExamples

Feb 2005: Invest $10,400 in Apple ComputerCurrent price $44.86 per share

1. Purchase entirely as shares in AAPL

2. Purchase 2000 July 16th (QAAGW) call optionsStrike price $47.50, premium $3.70

3. Purchase entirely as AAPL shares and write July 16thQAAGW call options to cover (COVERED CALLS)

4. Purchase 1000 call options and invest the remainder inhalf yearly Treasury Bonds paying 2% per six months

Plot returns for August share price of $35, 40, 45, 50, 60 70in each strategy

Reading

Essentials of InvestmentsPART ONE: Investments Background and IssuesMcGraw Hill: Bodie, Kane, Marcus

Lecture ThreeReturns, Risk and

PracticalityAndy Bower

www.alchemetrics.org

Essentials of Investments

Measuring Return• Arithmetic/Geometric/APR

Measuring Risk• Risk premium/Gambling/Speculating• Drawdown

Diversification• Efficient Frontier

The Efficient Market Hypothesis• Buy & Hold/Medium/Short terms

Measuring Return

Holding Period Return (HPR)• (Priceend – Pricestart + Dividend) / Pricestart• No account for Deposits/Withdrawals

Arithmetic Average Return• (Sum HPR over n periods)/n• Ignores compounding• Good estimate for future HPR returns

Geometric Average• (Sum HPR over n periods) root n• Equivalent single period return with same compounded

performance

Measuring ReturnIRR

Takes into account net cash flows

CF0 + CF1/(1+IRR)1 +CF2/(1+IRR)2+CFn/(1+IRR)n=0

Solve for IRR

Measuring ReturnAPR / EAR

Annual Percentage Rate (APR)• Used for regular nperiod cash flows• Ignores compounding• APR = HPRperiod x nperiod

Effective Annual Rate (EAR)• Includes compounding• Discrete Compounding:

1+EAR=(1+HPR)n

• Continuous Compounding:EAR=eAPR - 1

Measuring Risk

Expected Rate of Return E(r)• Consider probability of various scenarios and

the HPRs for each.

• E(r) = s p(s) HPR(s)

Risk can be measured as:• “expected” variance of HPR from E(r)

• Var(r) = s p(s) (HPR(s)-E(r))2

Measuring Risk

Risk Premium• A measure of the benefit of investing in a

“risky” asset compared to a “risk free” asset.• Typically E(r)-rf

Speculators• Require a risk premium• Trade off risk against expected return

Gamblers• Don’t require a risk premium

Effects of Risk

Drawdown• The % amount by which an investment fund

falls below its previous high.• Confidence factor

Example Trading SystemHypothetical ReturnsAPR=466%

BUT…. >40% drawdown>40% drawdownthree times in 2 yearsthree times in 2 years

Drawdown periodsDrawdown periodseach > 3monthseach > 3months

Diversification

nn

Risk standard deviationRisk standard deviationvsvs

Portfolio sizePortfolio size

Market riskMarket risk

2 Asset Portfolios

Portfolio rate of return• rp = wa ra + wb rb

Portfolio Expected Rate of Return• E(rp) = wa E(ra) + wb E(rb)

Portfolio Variance (Risk)• σp = (waσa)2 + (wbσb)2 + 2(waσa)(wbσb)ρab

Efficient Frontier

E(rE(r22))

22

Two Asset Expected ReturnTwo Asset Expected Return vsvs VarianceVariancePlot as asset weights varyPlot as asset weights vary

MinimumMinimumvariancevariance

combinationcombination

E(rE(rpp))

pp

Expected Return/VarianceExpected Return/VarianceOfOf Individual AssetsIndividual Assets

Portfolio Expected ReturnPortfolio Expected Return vsvs VarianceVariance““frontierfrontier”” as asset weights varyas asset weights vary

MinimumMinimumvariancevarianceportfolioportfolio

Efficient Market Hypothesis

If prices include all available information• Markets must be “efficient”• Price action must be unpredictable (random walk)• Called the Efficient Market Hypothesis (EMH)

Three forms• Weak Form EMH• Semi-Strong Form EMH• Strong Form EMH• All predict that Technical Analysis is without merit

In which case the following shouldn’t work…

Automated Trading Systems

Advantages• No Emotions• Timing

Disadvantages• Curve Fitting

Buy/Sell Signal Generation• Indicators• Neural Networks/Genetic Algorithms

System Analysis• Backtesting/Forward Testing/Montecarlo Analysis• Single/Multiple securities

Money Management• Risk-Reward/Position Sizing

Practical System AnalysisExamples

Simple System• Moving average crossover

Effect of Diversification• Multiple stocks

Effect of Money Management• Returns vs. Drawdown

Slippage• Market orders/Effective market orders

Personal Experience

7th year of trading on US markets

4th year of automated trading• Proprietary software for strategy building• Analysis tools• Automated order submission

You can read about this at www.alchemetrics.org

Automated Trading

My “Rules of Engagement”Don't trade "manually"; always use computer-based

automated systems.

Go Long wherever possible.

Look for systems that exploit distortions in themarket.

Trade portfolios rather than individual issues.

Keep systems simple.

Don't believe your analysis tools.

Reading

Essentials of InvestmentsBodie, Kane, Marcus: McGraw-Hill

• Risk and Return• Efficient Diversification

Further Reading

Trade Your Way to Financial FreedomTharp: McGraw-Hill