FOREX SCIENTIFIC APPROACH TO SYSTEM DEVELOPMENT

FOREX SCIENTIFIC APPROACH TO SYSTEM DEVELOPMENT

Intended to accomplish a systematic and detailed analysis of the individual components that make up a complete trading system. We are proposing nothing less than a scientific study of entries, exits, and other trading system elements. The basic substance of the scientific approach as applied herein is as f0110ws:

1. The object of study, in this case a trading system (or one or more of its elements), must be either directly or indirectly observable, preferably without dependence on subjective judgment, something easily achieved with proper testing and simulation software when working with complete mechanical trading systems.

2. An orderly means for assessing the behavior of the object of study must be available, which, in the case of trading systems, is back-testing over long periods of historical data, together with, if appropriate, the application of various models of statistical inference, the aim of the latter being to provide a fix or reckoning of how likely a system is to hold up in the future and on different samples of data.

3. A method for making the investigative task tractable by holding most parameters and system components fixed while focusing upon the effects of manipulating only one or two critical elements at a time.

Trading systems are dissected into entry and exit models. Standardized methods for exploring these components independently are discussed and implemented, leading to separate sections on entries and exits. Objective tests and simulations are run, and statistical analyses are performed. Results are presented in a consistent manner that permits direct comparison. This is “old hat” to any practicing scientist.

Many traders might be surprised to discover that they, like practicing scientists, have a working knowledge of the scientific method, albeit in different guise!

Books for traders often discuss “paper trading” or historical back-testing, or present results based on these techniques. However, this book is going to be more consistent and rigorous in its application of the scientific approach to the problem of how to successfully trade the markets. For instance, few books in which historical tests of trading systems appear offer statistical analyses to assess validity and to estimate the likelihood of future profits. In contrast, this book includes a detailed tutorial on the application of inferential statistics to the evaluation of trading system performance.

Similarly, few pundits test their entries and exits independently of one another. There are some neat tricks that allow specific system components to be tested in isolation. One such trick is to have a set of standard entry and exit strategies that remain fixed as the particular entry, exit, or other element under study is varied. For example, when studying entry models, a standardized exit strategy will be repeatedly employed, without change, as a variety of entry models are tested and tweaked. Likewise, for the study of exits, a standardized entry technique will be employed. The rather shocking entry technique involves the use of a random number generator to generate random long and short entries into various markets!

Most traders would panic at the idea of trading a system with entries based on the fall of the die; nevertheless, such entries are excellent in making a harsh test for an exit strategy. An exit strategy that can pull profits out of randomly entered trades is worth knowing about and can, amazingly, be readily achieved, at least for the S&P 500 (Katz and McCormick, March 1998, April 1998).

The tests will be done in a way that allows meaningful comparisons to be made between different entry and exit methods.

To summarize, the core elements of the scientific approach are:

1. The isolation of system elements

2. The use of standardized tests that allow valid comparisons

3. The statistical assessment of results