Designing Stock Market Trading Systems: With and without soft computing

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First published in Great Britain in 2010 by Harriman House.

This eBook edition 2011.

Copyright © Harriman House Ltd

The right of Bruce Vanstone and Tobias Hahn to be identified as the authors has been asserted in accordance with the Copyright, Design and Patents Act 1988.

978-0-85719-135-9

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Preface

Many people know of the stock market as a place to make and lose large sums of money. Unfortunately for most people, their knowledge stops there. Some go a little further, and attempt to trade in the markets, often using a discretionary approach, buying or selling as their mood dictates. These people will find it very difficult to succeed. The market is not very tolerant of learners.

A few hardy souls venture further still. They take the time to study what others have done before them, and try to learn what it takes to be successful. These people will discover that there are no real trading secrets, and that it is relatively easy to develop a profitable trading system. The difficulty is not in creating successful trading rules, but in following them.

This book is about developing mechanical stock market trading systems. It demonstrates a methodology for creating successful trading systems, using both fundamental and technical data. It demonstrates how to test trading systems, and how to enhance them using artificial intelligence (soft computing) techniques. These days, most of us have access to relatively powerful computers and software. The techniques needed to develop successful trading systems are well within our reach. So too are the techniques used to enhance trading systems with soft computing.

This book is a ‘how-to guide’ for developing successful stock market trading systems. It is for beginners, discretionary traders, and systematic traders alike. For beginners and discretionary traders, it provides a roadmap to follow for creating rule-based trading systems. For existing systematic traders, it presents information on testing, benchmarking, and enhancing systems using soft computing.

Systematic trading allows us to test out our ideas in many different markets and time frames, and see how well they would have worked in the past. Of course, success in the past is no guarantee of success in the future. However, if a method has worked well in the past, it is more likely to succeed in the future than a method that has never worked before.

Try and think of this book as a starting point for your own trading journey. The chapters are designed to support your growing knowledge as your understanding of the methodology grows. Our coverage of each topic is by no means exhaustive. We have tried to include the information we think you need to know to follow the methodology. You should consider the information we present in each chapter as the minimum amount of information you will need. There is a bibliography at the end of the book, with separate lists of sources for each chapter, which you can use to track down related information as your needs dictate.

How this book is structured

The book is divided into the following ten chapters:

1. Designing Stock Market Trading Systems

Chapter 1 introduces the ideas underpinning stock market trading, both from a practical and academic perspective. It explains why most traders fail, and explains what you must do to succeed. It also explains the reasons why you are more likely to be successful as a systematic, rules-based trader compared to a discretionary trader. Finally, it introduces the idea of soft computing, and explains the reasons why soft computing can have such a profound effect on trading performance.

2. Introduction To Trading

Chapter 2 presents a very brief introduction to trading. It provides you with information on some of the basic approaches that traders use to try and make money in the markets. Its main goal is to stimulate you to think about the kinds of approaches you would like to learn more about. One of the most common flaws for beginners is to try and trade everything they come across in the market. A far better approach is to develop systems to identify specific behaviours, and to wait on the sidelines until the required behaviour is identified.

3. Fundamental Variables

Chapter 3 introduces fundamental variables. These variables provide the means to codify fundamental observations about companies, which are later expressed in the form of a trading strategy. This chapter discusses the academic acceptance of these types of variables, and presents a historical evolution of academic research into these variables. As always, it is important to ensure the findings of published research are applicable to your own trading universe – by which we mean the assets or indices you will allocate your money to. This chapter includes a case study that demonstrates techniques that you can use to gain insights into the effects of many fundamental variables.

4. Technical Variables

Chapter 4 introduces technical variables. These variables provide the means to codify behavioural observations about markets and stocks, which will later be expressed in the form of a trading strategy. This chapter discusses the academic credibility of these types of variables, and presents a historical evolution of academic and practitioner research into them. This chapter contains a case study that verifies the credibility of technical analysis.

5. Soft Computing

Chapter 5 introduces you to the various soft-computing paradigms, and shows how soft computing can complement trading systems. It also helps you to gain an understanding of the advantages and disadvantages of soft computing. There is also a detailed review of academic work focused on the use of soft computing in trading, including a brief summary of each work, and its outcomes.

6. Creating Artificial Neural Networks

Chapter 6 explores Artificial Neural Networks (ANN) in greater detail. It describes the process of designing, training and testing an ANN for use within a trading system.

7. Trading Systems And Distributions

Chapter 7 describes the first of the two primary approaches to benchmarking trading systems. It introduces you to the raw trades approach, describing both traders’ metrics and statistical measures used for benchmarking.

8. Position Sizing

Chapter 8 introduces the concept of money management, also referred to as position sizing. It surveys the common solutions used by traders, and opens up new questions in this area.

9. Risk

Chapter 9 introduces the concept of risk. It studies what people mean by risk, how they measure it, and what they try to do with it. As well as describing the various metrics, this chapter introduces the Monte Carlo technique for estimating risk, and relates the area of risk to the previous chapter on position sizing. This chapter contains a case study that shows you how to see if stops are helping or hindering your own trading system.

10. Case Studies

Chapter 10 develops two complete trading strategies from scratch, one based on fundamental variables, and one based on technical variables. It demonstrates the methodology in practice, and shows the importance of relying on published research to build trading systems.

We wish you every success on your trading journey. You can take it from us that trading in the markets is entertaining, challenging and certainly never boring.

Bruce Vanstone and Tobias Hahn

Acknowledgements

This book is a product of many years of trading research, and along the way I have been fortunate enough to learn from both academics and practitioners alike.

From an academic perspective, this book is the explanation of the trading system development methodology I created during my PhD in Computational Finance at Bond University in Australia. During my time at Bond University, I am fortunate to have been influenced by academics of the highest quality, such as Professor Gavin Finnie, and Professor Kuldeep Kumar. I am always grateful for their advice and direction. I am also grateful for the tireless efforts of my PhD student, Tobias Hahn, who has helped write (and rewrite) this book.

From a practitioners’ perspective, I am grateful to Tony Porter. He has given generously of his time and advice. His comments are always insightful and his trading skills are of the highest quality.

I would like to thank Norgate Investor Services (www.premiumdata.net) for the use of their data, and also Morningstar’s FinAnalysis (www.morningstar.com.au) for providing fundamental data.

Finally, I am thankful to my wife, Sue, and to my children, Daisy and Serena, for giving me the time and encouragement necessary to pursue my dreams. Also, I am thankful to Sue for the many hours she has spent toiling over the manuscript with a red pen. She has worked hard to ensure that the ideas and explanations I have put forward in this book are comprehensible.

Introduction

There can be few people in the world today whose lives are not in some way impacted by the stock markets. The financial crisis that began in late 2007 and early 2008 is proof of how complex and interlinked the world’s markets have become. The subsequent meltdown in virtually all the world economies demonstrates the awesome power the markets exert over our financial systems.

My starting point with trading was probably much the same as yours. I put my toe in the water and got it burned.

At that point I decided I wouldn’t continue with trading until I understood what I was doing. So I started reading and learning as much as I could about trading and how markets worked. Somewhere along that path, I completed a PhD in Computational Finance at Bond University in Australia. I tested a great deal of trading software, performed endless optimisations, and tested some of the craziest ideas you could imagine. By the time I finished my PhD, I had created my own methodology for designing stock market trading systems, which I still use to this day. I have taught this methodology to students in my Computational Finance classes, and to other traders. It is also used to create the stock market trading systems in a boutique hedge fund that I provide consultancy services for.

Eventually, it became clear to me that there are no secrets in trading. Trading is about finding an edge and exploiting it. Modern computers and software provide us enough power to design and test until we find our trading edge. The sad irony is that most people don’t know how to go about designing trading systems, and don’t know how to go about finding their edge. They don’t seem to understand that there is an army of academics, myself included, who produce vast quantities of trading research. This research is gold dust, because it provides information about what works and what doesn’t work in trading.

Better still, most of this information can be unearthed on the internet for free. What is missing is a way to incorporate other peoples’ ideas and research into your own trading systems. That’s where my methodology fits in. It shows you how to test existing research, how to take advantage of it by developing it into a rule-based trading system, and even how to improve it with soft computing.

Chapter 1 –Designing Stock Market Trading Systems

Tips are for waiters.

Daryl Guppy

1.1 Introduction

This book is designed to assist the reader with two main fields of study, namely:

Designing mechanical stock market trading systems, and

Using soft computing to enhance mechanical stock market trading systems.

This book presents a defined methodology for creating financially viable mechanical stock market trading systems, both with and without soft computing.

The design methodology presented here sees the building of mechanical stock market trading systems as the assembly of a number of tested components. This book explains the function of these components, and relates them to previously published academic research. Further, it demonstrates appropriate metrics to test individual components, and also to test the finished product; the trading system.

The process of building mechanical stock market trading systems is not a linear one. Although each function can be studied separately, the resultant trading system is a complex interaction between all the components, with the operation of each component affecting the others (and perhaps even itself).

For this reason, it is necessary to study each of the main functions separately, and have a solid understanding of what each function is designed to do. When this objective has been reached, it is then time to start considering the interactions between the functions. When all the functions are working together in harmony, the result is a highly usable trading system.

1.2 Motivation

A primary motivation for writing this book was to provide aspiring trading system developers with a design methodology to follow. Many approach the task as if it were a ‘black art’, endlessly thrashing with a vast array of technical indicators in the unlikely hope of suddenly pulling a successful system out of the chaos. There is no justification for this style of system development, which eventually becomes bogged down in data mining and curve-fitting until it finally ends with analysis paralysis. [¹]

Designing successful stock market trading systems is a complex, nonlinear process. The methodology presented in this book was the one I created and defined in my own PhD journey, which eventually culminated in my PhD thesis, ‘Trading in the Australian Stock Market using Artificial Neural Networks’. [²]

A defined methodology breaks a complex process up into smaller, more manageable pieces, and then allows a way for each piece to be specified and tested against those specifications. Finally, it provides a way to assemble the pieces, and to test the finished product.

Without methodology, a designer is lost. The design process becomes akin to an infinite number of monkeys at the keyboard. There is no real progress except by luck. There is no way to evaluate intermediate results, as there is no real understanding of their contribution to the overall goal.

The first step is to break this cycle, and begin the process of design. To do this, it is essential to understand the goal, the components that need to be built, and the constraints that exist.

1.3 Scope and data

The methodology presented in this book is applicable to many markets, instruments and traders.

Dependant on the example, it may use fundamental and/or technical data, which was sourced under the following conditions:

Technical data (open, high, low, close, volume) was sourced from Norgate Financial Services (2008). The technical data in the case studies in Chapter 10 covers ordinary shares in the S&P ASX200 (2004), during the time frame 3 April 2000 (index creation) to 31 December 2008. The data includes delisted stocks and is adjusted for dilutions, stock splits, and consolidations.

Fundamental data was sourced from the Aspect Financial Services database FinAnalysis (2004). This source provides detailed fundamental information for all companies listed on the ASX, and also maintains this data for delisted companies. In this book, the use of all fundamental data has been delayed for six months from the end of the financial year, which is (due to reporting requirements), well after the publication date. We store our fundamental data in a Microsoft Access database, and you will see an include named ‘Book_QFDBLib2’ in our examples that use fundamental data. This include is our way of connecting to the fundamental data we have stored in Microsoft Access. To repeat our examples when you are investing, you will need to replace this and the relevant fundamental data accesses in our examples with whatever code is required for you to connect to your own fundamental data source.

Where simulations are given, transaction costs are always taken into account. Transaction costs of $50 each way are used, and simulations also include slippage of 0.5%.

It is assumed that you will want to repeat the case studies in your own investing and, indeed, you are encouraged to do so. You should be aware that the S&P ASX200 was chosen for these examples mainly due to its high liquidity. If you are repeating these examples with different stock indices you should ensure there is adequate market depth to enable you to actually place trades (particularly exits). This caution is especially important if you are trying to trade amongst the penny stocks, which are notorious for being illiquid.

1.4 The efficient market