Trading Systems and Methods

1. Technical Analysis: Beyond Fundamentals

In many ways, there is no conflict between fundamental and technical analysis.

Two Sides of the Same Coin. Technical analysis focuses on price, volume, and open interest, while fundamental analysis examines supply, demand, and economic factors. Both approaches aim to understand market behavior, but they use different tools and perspectives. Technical analysis is self-contained, relying solely on market data, while fundamental analysis requires external information.

Timing is Key. Fundamental analysis may identify long-term trends, but technical analysis provides tools for timing entries and exits. Technical analysis is particularly useful in futures markets, where high leverage necessitates a focus on short-term price fluctuations.

Market Anticipation. Technical analysis assumes that the market reflects all known information, including the expectations of future events. This makes it a powerful tool for identifying recurring patterns and anticipating price movements.

2. Data is King: Understanding Averages and Distributions

The most prudent investor therefore, is one who pursues only a general course of action which is "normally" right and who avoids acts and policies which are—normally—wrong.

Averages are not enough. While averages provide a central tendency, they can be misleading without understanding the distribution of data. The arithmetic mean, geometric mean, and harmonic mean each have unique properties and are best suited for different types of data.

Distribution matters. Frequency distributions, medians, and modes help to understand the shape and extremes of price movement. Standard deviation measures the dispersion of data around the mean, while skewness and kurtosis quantify the asymmetry and peakedness of the distribution.

Data bias. It is important to be aware of bias in data, which can be introduced through sampling, weighting, or the use of multiple analytic methods. Sufficient data is needed to reduce the error factor and ensure the reliability of any trading system.

3. Regression Analysis: Unveiling Relationships

Regression analysis is a way of measuring the relationship between two or more sets of data.

Linear and Nonlinear Relationships. Regression analysis uses statistical methods to determine the relationship between variables. Linear regression finds the best-fit straight line, while nonlinear methods, such as curvilinear, logarithmic, and exponential approximations, can capture more complex relationships.

Method of Least Squares. The method of least squares is a popular technique for finding the best fit by minimizing the sum of the squares of the errors. This method can be used to find the slope, y-intercept, and correlation coefficient.

Correlation and Causation. The correlation coefficient measures the strength of a linear relationship between two variables, ranging from +1 to -1. However, correlation does not imply causation, and it is important to avoid spurious relationships.

4. Trend Calculations: Isolating the Signal from the Noise

The purpose of all trend identification methods is to see past the underlying noise in the market, those erratic moves that seem to be meaningless, and find the current direction of prices.

Forecasting vs. Following. Forecasting attempts to predict future prices, while following identifies the current trend. Autoregressive models use past prices to predict future prices, but they are limited by their reliance on historical data.

Least Squares and Moving Averages. The least-squares method can be used to find the relationship between time and price, while moving averages smooth price movement by averaging past data. The choice of time interval is critical for both methods.

Variations on Moving Averages. There are many variations on the moving average, including weighted, geometric, harmonic, and average-modified. Each method has its unique properties and is best suited for different types of data.

5. Trend Systems: Putting Theory into Practice

The simplest way to avoid these price variations is by using a band.

Basic Buy and Sell Signals. Trend systems generate buy signals when prices cross above the trendline and sell signals when prices cross below. These signals can be modified by using closing prices, bands, or delays.

Bands and Channels. Bands and channels are used to define areas of support and resistance around a trendline. They can be based on percentages, absolute point values, or volatility.

Examples of Trend Systems. The MPTDI system uses a step-weighted moving average with a band of changing widths. The Volatility System generates signals based on price changes relative to average volatility. The 10-Day Moving Average Rule uses a simple moving average with a band based on the high-low range.

6. Momentum and Oscillators: Measuring the Speed of Change

Momentum is the difference between two prices taken over a fixed interval.

Momentum as Speed. Momentum measures the rate of price change over a specific time interval. It is related to the slope of a price trend and can be used to identify overbought and oversold conditions.

Oscillators as Normalized Momentum. Oscillators are normalized momentum indicators that are bounded within a specific range, such as +1 to -1 or 0 to 100. Examples include the Relative Strength Index (RSI) and the stochastic oscillator.

Divergence and Convergence. Divergence occurs when prices and momentum move in opposite directions, indicating a potential trend reversal. Convergence occurs when prices and momentum move in the same direction, confirming the trend.

7. Seasonality: The Rhythms of the Market

Price is the balancing point of supply and demand.

Consistent Patterns. Seasonality refers to recurring patterns that occur yearly, often related to planting and harvesting cycles. These patterns can be measured using frequency distributions, averages, medians, and modes.

Elasticity of Supply and Demand. The elasticity of supply and demand is a key factor in understanding price movement. The point of equilibrium is where supply and demand meet, and this point can shift due to changing factors.

Cobweb Charts. Cobweb charts can be used to visualize the shift in sentiment between supply and demand, producing sideways markets or increasing volatility. Models that explain price movements must be constructed from the primary factors of supply and demand.

8. Cycle Analysis: Uncovering Hidden Patterns

Change is a term that causes great anxiety. However, the effects and likelihood of a chance occurrence can be measured, although not predicted.

Cycle Basics. Cycles are recurring patterns in price movement that are not necessarily annual. They can be caused by business decisions, government programs, or behavioral factors.

Uncovering the Cycle. Cycles can be uncovered using trigonometric curve fitting, which approximates price movement using sine and cosine waves. Fourier analysis (spectral analysis) is another method that isolates and measures the cycles within a data series.

Maximum Entropy. Maximum Entropy Spectral Analysis (MESA) is a technique that filters noise from a time series and exposes the underlying cycles. It is particularly useful for short-term cycles.

9. Charting: Visualizing Market Behavior

The market reflects all the jobber knows about the condition of the textile trade; all the banker knows about the money market; all that the best-informed president knows of his own business, together with his knowledge of all other businesses; it sees the general condition of transportation in a way that the president of no single railroad can ever see; it is better informed on crops than the farmer or even the Department of Agriculture.

Interpreting the Bar Chart. Bar charts are the simplest representation of the market, showing the high, low, and closing prices for each period. Chart formations, such as trendlines, channels, and tops and bottoms, are used to identify potential trading opportunities.

Candlestick Charts. Candlestick charts are a Japanese method of charting that uses shaded bodies to represent the relationship between the opening and closing prices. They are used to identify reversal patterns and other trading signals.

Volume, Open Interest, and Breadth. Volume, open interest, and breadth are used to gauge market participation and confirm price trends. Volume should expand with the trend, and open interest should increase during a trending period.

10. Volume, Open Interest, and Breadth: Gauging Market Participation

The market now supports dozens of major funds and managed programs, which account for a sizable part of futures market open interest and operate primarily by decisions based on "technical analysis."

Contract Volume vs. Total Volume. Contract volume refers to the volume of a specific delivery month, while total volume is the sum of all contracts in a market. Total volume is more useful for analyzing overall market activity.

Standard Interpretation. Volume is used to confirm price trends. Rising prices with rising volume are considered bullish, while falling prices with rising volume are considered bearish. Open interest measures the total number of outstanding contracts.

Volume Indicators. Volume indicators, such as On-Balance Volume (OBV), Price and Volume Trend (PVT), and the Market Facilitation Index (MFI), combine price and volume data to generate trading signals. Breadth measures the number of advancing and declining issues in the stock market.

11. Point-and-Figure Charting: Precision in Price Action

Point-and-figure charts are popular because they offer specific trading rules and show formations similar to both bar charting and ticker-tape trading.

Plotting Prices. Point-and-figure charts plot prices using Xs and Os, with each box representing a specific price increment. The direction of the price movement is indicated by the column of Xs or Os.

Chart Formations. Point-and-figure charts use formations similar to bar charts, such as trendlines, channels, and tops and bottoms. However, they are more precise and offer specific trading rules.

Box Size and Reversal. The box size and reversal value determine the sensitivity of the chart. A smaller box size and reversal value will generate more signals, while a larger box size and reversal value will generate fewer signals.

12. Behavioral Techniques: The Human Element in Trading

Much of the price movement reflected in commodity cash and futures markets is anticipatory; the expectations of the effects of economic developments.

Measuring the News. News events can have a significant impact on market prices. The impact of news can be measured by assigning values to different types of news and combining them to get a net score.

Event Trading. Event trading focuses on the market reaction to price shocks. It involves studying the patterns that follow unexpected news and using them to generate trading signals.

Contrary Opinion. Contrary opinion is a trading philosophy that seeks to profit from the actions of the crowd. It involves taking positions opposite to the prevailing market sentiment.

Last updated: February 1, 2025