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2

Preface

upside and downside potential by creating trading zones. Chapter 12 reveals a technique for switching among time frames. Chapter 13 supports the practice of using diversification to improve system reliability.

Part IV discusses the advanced issues of constructing market models as powerful indicators. Chapter 14 illustrates by examples the power of including intermarket analysis. Chapter 15 notes the importance of using the correct paradigm for modeling the market and how, by failing to do so, current models fall short of exploiting some market inefficiencies. In particular, the author shows how an improper paradigm is skewing modern option pricing models-information that can be exploited by the sawy trader. Chapter 16 reveals how properly preprocessing financial data prior to modeling can greatly enhance system accuracy. Chapter 17 offers an example of how to model the market using the Statistical Data Mining technique. Chapter 18 is a complete case study on building an advanced trading system.

The appendices cover the practical issues of gathering knowledge and data. Appendix A provides a brief overview of the issues when selecting a financial data provider as well a list of data vendors and their services. Appendix discusses, in fine detail, how financial data is generated and transmitted through vendors to your computer, and all the things that can go wrong along the way. Appendix includes Web hyperlinks to three of my collections: (1) financial book reviews written by real traders, (2) quality trading system programmers for Omega Research products, and (3) worthwhile software companies whose products are useful in market forecasting. Appendix D is a short true story about lessons learned, as relevant today as it was decades ago. Appendix E introduces all the contributing authors to this book

Editing a book this size was a task whose sheer enormity overwhelmed me. So, in addition to the authors of each chapter, I relied heavily on the contributions of many experienced traders, especially through these four moderated forums on the Internet:

• ati@sciapp.com

• scilink@sciapp.com

• omega-list@eskimo.com

• realtraders@listserver.com

To make it easier to find up-to-date information about a product or service mentioned in this book, I have included identifying hyperlinks to relevant Web sites. However, to ensure these hyperlinks will not age, I have included only those links that point to original domains and not to accounts within an Internet service provider (ISP).

I hope you will carefully consider all the issues discussed in this book before deciding what to purchase. Your adventure in computerized trading will cost you a small fortune. Oh, yes it will.

May you acquire an even greater fortune.

Mark Jurik



Introduction

Playing the markets is very much a competitive sport, and to be in the small circle of winners you must commit time, effort, and money. More than you might guess. You will need to make many decisions regarding these three issues, especially when you intend to use a personal computer as part of your trading system.

Can you imagine any institutional investor playing with billions of dollars and not having an entire computer facility dedicated to analyzing the markets? Facing this opposition, do you stand even a remote chance of making a profit? Yes, but salvation will not come from a basket of nifty indicators that thousands of others already use. To chisel out profit from the markets inefficiencies, you are going to need market insight, trading skill, and all the edge you can get, including computerized trading.

By "market inefficiencies" I am referring to any market behavior that can be predictably exploited. The tulip mania of seventeenth-century Holland was the result of people anticipating the demand of others, who in turn were anticipating the demand of others, and so on. Consequently, tulip prices rose astronomically, followed by the inevitable crash. A few speculators made fortunes in a short period of time. This is a classic case of an inefficient market.

Has modern technology, with all its rapid information transmission and processing, virtually eliminated market inefficiencies? Could the masses be so wrong in modern times? Well, yes. There is mounting evidence that the market is still filled with opportunities, and that as new financial instruments appear, they create both inefficiencies and predictabilities that await exploitation. This is due to the diverse makeup of traders-people have different investment horizons (short- or long-term), attitudes toward risk (those with deep pockets versus those without), sensitivity to news and public opinion (mob psychology), and trading technology (which affects response times).

Inefficiencies also occur because the "markets" are people, making the same greedy, panicked decisions day in and day out-dumping a position at the bottom, jumping into already overbought markets. (Remember the craze for junk bonds?) As a consequence, not all value is immediately discounted. Predictable behavior still remains. For example, market action alternates between clusters of high and low volatility, and certain price behaviors, such as trendiness, are more predictable within these clusters.

What has changed since the seventeenth century is the level of sophistication needed to both find and profit from market patterns. Computers and advanced pattern matching are at home here, as are the hordes of physicists and mathematicians who have been crawling around Wall Street ever since the cold war ended.



Introduction

Because of this high-tech onslaught, good old reliable cycles have little staying power. They are exploited and discounted as soon as they are discovered. In the past 5 years, there has been a tangible drop in the profitability of simple, standard systems based on canned indicators such as moving averages, the Relative Strength Index (RSI), or stochastics. One trader lamented, "I doubt that even the Turtles could make the same money today using the same methods as a decade ago."

So what is left for the individual investor? Will all the good opportunities be taken by large institutions that can afford to hire Ph.D. analysts? Well, no. Considering that 90 percent of all traders are losing money in the markets, there is lots of treasure to be had. But you will need more than pencil and paper to get your share. Profitability requires sophisticated analysis that can dig out short-term persistence in price/volume behavior, a brief incident of cyclic action, correlation between two or more markets with predictive value, and so on. To gather, analyze, and detect profitable market inefficiencies, you will need at least one computer. It will not guarantee profits, but it can provide the sophisticated evaluation of market activity that simply was not necessary a decade ago.

To succeed, you need to find those investment techniques that work for you. This includes having faith in your system, as well as having effective money management and entry-exit timing. Faith depends not only on how well your system is performing, but also how well you understand what it is doing. It is all too easy to get cold feet and try to outsmart your system, only to end up worse off than if you stuck to your guns.



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