Kirkpatrick and Dahlquist, CMT1 Chapter 22

Part VII: System Testing and Management

Chapter 22: System Design and Testing

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• Chapter Objectives
  • The importance of using a system for trading or investing
  • The difference between a discretionary and a non-discretionary system
  • The mind-set and discipline required to develop and trade with a system
  • The basic procedures for designing a system
  • The role that risk management plays in system design
  • How to test a system
  • Standard measures of system profitability
• Why are systems Necessary?
• Discretionary Versus Non-discretionary Systems
  • Benefits of a Non-discretionary, Mechanical System
  • Pitfalls to a Non-discretionary, Mechanical System
• How Do I Design a System?
  • Requirements for Designing a System
  • Understanding Risk
  • Initial Decisions
• Types of Technical Systems
  • Trend Following
  • Moving Average Systems
  • Breakout Systems
  • Problems with Trend-Following Systems
  • Pattern Recognition Systems
  • Countertrend Systems
  • Exogenous Signal Systems
  • Which System Is Best?
• How Do I Test a System?
• Special Data Problems for Futures Systems
• Testing Methods and Tools
• Test Parameter Ranges
• Designing a System– The “Nerves of Steel System”
  • System Statistics
    • Net profit
    • Gross profit and gross loss
    • Profit factor
    • Number of trades
    • Percent profitable
    • Average trade net profit
    • Largest winner or loser versus gross profit or gross loss
    • Maximum consecutive losing trades
    • Average weeks in winning and losing positions
    • Buy-and-hold return
    • Return on account
    • Average monthly return and standard deviation
    • Sharpe ratio
    • Maximum drawdown
    • Net Profit as Percentage of Maximum Intraday Drawdown
• Optimization
  • Methods of Optimizing
    • Whole Sample
    • Out-of-Sample (OOS)
    • Walk Forward Optimization
    • Optimization and Screening for Parameters
• Measuring System Results for Robustness
  • Intro
    • Robustness simply means how strong and healthy our results are
    • Robustness refers to how well our results will hold up to changing market conditions
  • Components
  • Profit Measures
    • Profit factor
    • Outlier-adjusted profit
    • Percentage winning trades
    • Annualized rate of return
    • Payoff ratio
    • Length of the average winning trade
    • Efficiency factor
  • Risk Measures
    • Maximum cumulative drawdown
    • Net profit to drawdown ratio
      • Also called “recovery ratio”
    • Maximum consecutive losses
    • Large losses
    • Longest flat time
    • Time to recovery
    • Maximum favorable and adverse excursions
    • Sharpe ratio
    • Other risk measures in the literature:
      • Return Retracement ratio
      • Sterling ratio (over three years)
      • Maximum loss
      • Sortino ratio
    • Smoothness and the Equity Curve
      • Equity curve
      • Underwater curve
  • What Is a Good Trading System?
    • From the book: Beyond Technical Analysis, by Tushar Chande
      • Positive expectation
        • Greater than 13%
      • Small number of robust trading rules
        • Less than ten each is best for entry and exit rules
      • Able to trade multiple markets
        • Can use baskets for determining parameters, but
        • Rules should work across similar markets
          • different stocks
          • different commodities
          • different futures, etc.
      • Incorporates good risk control
        • Maximum risk should not be more than 20% drawdown
        • 20% drawdown should not last more than 9 months
• Conclusion
• Review Questions

Proceed to Chapter 23: Money and Risk Management (in Kirkpatrick and Dahlquist)

Chapter list for Kirkpatrick and Dahlquist