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1

complete the model with a brief analysis of some common technical analysis indicators and their impact on system performance.

In each of Chapters 2 through 7, we design and develop a trading system based on a single concept. We define the system rules, code it in accordance with the trading model, and then present some examples of actual trades with charts and rationale.

In Chapter 8, we create two market models using two different approaches. First, we apply all of the trading systems to various market and sector indices to create a bottoms-up model. Then, we adapt the pattem trading system to a set of sentiment indicators to create a top-down model, comparing the results of each model.

Chapter 9 takes the professional trader through a real-time trade analysis from the closing bell of one day to the opening bell of the next. The daily cycle of position management and chart review is described in detail.

Chapter 10 presents a different perspective on day trading. After a brief Level II tutorial, we show how any trading system can be adapted to intraday time frames. Here, we introduce several day trading techniques that integrate traditional technical analysis with direct access tools.

Chapter 11 is the complete implementation of a trading model, including source code for money management, position management, and a complete set oftrading systems. The code can be compiled into TradeStation, and the executable code can then be run as a professional trading platform.

In writing this book, we acknowledge the achievements of some of the lesser-known yet influential technicians who approached the market from an apphed scientific perspective: Dunnigan, Gartley, Schabacker, and Taylor. We can only imagine their reaction to the images of charts and indicators being drawn in real-time as a soothing voice tells the trader when to buy and when to seU.

The next generation of trading software is already being written to merge the world of trading with the world of software-the integration of price streams with scripting languages, the transparency of database access to many sources of market data, and the dynamic composition of new types of market instruments synthesized from the fine granularity of multiple data feeds. The evolution oftrading from art to science is just beginning.

Mark Conway Aaron Behle

San Diego, California April 2002

Contents

PREFACE CONTENTS TABLE OF FIGURES

IX XI XVII

1 INTRODUCTION 1

1.1 Acme Trading Systems................................................................2

1.2 System Summary..........................................................................4

1.3 Chart Indicators...........................................................................5

1.4 A Trading Model........................................................................6

1.4.1 Portfolio......................................................................................7

1.4.2 Trade Manager.........................................................................12

1.4.3 The Trading System..................................................................19

1.4.4 Trade Filters..............................................................................22

1.5 Performance.............................................................................32

1.5.1 A Tale of Two Stocks................................................................34

2 PAIR TRADING 39

2.1 The Spread................................................................................40

2.2 Spread Bands.............................................................................41

2.3 Short Selling..............................................................................44

23.1 NYSE Rules..............................................................................44

2.3.2 Nasdaq Rules.............................................................................45

2.4 Hedging....................................................................................45

2.5 Pair Trading System (Acme P)....................................................46



2,11 Long Short

2.5.2 Short A Long H Rules

2.6 Examples...............................................

2.6.1 Activision - THQ

2.6.2 THQ - Activision

2.6.3 Apaclie-Anadarko

2.6.4 AUstate-Progressive

2.6.5 Emulex-QLogic

2.6.6 RF Micro Devices-TriQuint Semiconductor

2.7 Pair Trading Strategies.......................................

2.7.1 Tips and Tecliniques

Incorporated......

........51

52 54 55 56 57

..58

3 PATTERN TRADING 61

3.1 Market Patterns.........................................................................62

3.1.1 Cobra (C) 62

3.1.2 Hook (H) 63

3.1.3 Inside Day 2 (I) 64

3.1.4 Tail (L) 64

3.1.5 Harami (M) 66

3.1.6 Fullback (P) 67

3.1.7 Test (T) 68

3.1.8 V Zone (V) 69

3.2 Pattern Qualifiers......................................................................70

3.2.1 Narrow Range (N) 70

3.2.2 Average (A) 71

3.3 Pattem Trading System (Acme M)..............................................72

3.3.1 Long Signal 72

3.3.2 Short Signal 73

3.4 Examples...................................................................................79

3.4.1 Abgenix 79

3.4.2 PMC-Sierra 80

3.4.3 Checkpoint Software 81

3.4.4 New York Futures Exchange 82

3.4.5 Comverse Technology 83

3.4.6 Nasdaq Composite Index 83

3.4.7 Computer Associates 84

85 ..87

..92

..97 ...97 ...98 ...99 .100 .101 .102

.102

5 GEOMETRIC TRADING

5.1 Rectangle.........................................

5.2 Rectangle Trading System (Acme R).

5.2.1 Long Signal

5.2.2 Short Signal

5.3 Examples.......................................

5.3.1 AirGatePCS

5.3.2 Rambus

5.3.3 Electro-Optical Engineering

5.3.4 Stericycle

5.4 Double Bottom..............................

5.5DoubleTop....................................

5.6 Triple Bottom................................

5.7 Triple Top.....................................

5.8 Triangle..........................................

105 .106

.109

,109 .110

.112

.112 ..113 .114 ..114

,1)6

,118

.1)9

.1)9

4.1 Float Box........

4.2 Float Channel.

4.3 Float Percentage.........................

4.4 Float Trading System (Acme F) ...

4.4.1 Breakout System (Acme FB).

4.4.2 Pullback System (Acme FP)..

4.5 Examples..........................

4.5.1 THQ Incorporated

4.5.2 Juniper Networks

4.5.3 Ariba,

4.5.4 Ciena

4.5.5 Checkpoint Software.

4.5.6 FLIR Systems

4.6 Float Trading Strategies....



XIV Contents

6 VOLATILITY TRADING 123

6.1 Linear Regression....................................................................124

6.2 Volatility Trading System (Acme V)..........................................126

6.2.1 Long Signal............................................................................127

6.2.2 Short Signal.............................................................................127

6.3 Examples................................................................................129

6.3.1 Microsemi Corporation...........................................................129

6.3.2 Veritas Software.....................................................................131

6.3.3 webMethods............................................................................1?1

6.3.4 SeaChange...............................................................................132

6.3.5 Biotechnology Index................................................................133

6.3.6 Computer Associates...............................................................133

7 RANGE TRADING 135

7.1 Range Ratio.............................................................................136

7.2 Range Patterns........................................................................137

7.2.1 Inside Day 2 (ID2)..................................................................137

7.2.2 Inside Day-Narrow Range 4 (IDNR4)....................................138

7.2.3 Narrow Range 2 (NR2),..........................................................138

7.2.4 Narrow Range 10 (NRIO)........................................................139

7.25 Narrow Range % (NR%),........................................................139

7.3 Range Trading System (Acme N)..............................................140

7.3.1 Long Signal............................................................................141

7.3.2 Short Signal.............................................................................142

7.4 Examples.................................................................................145

7.4.1 Nasdaq Composite Index........................................................145

7.4.2 Securities Broker/Dealer Index................................................147

7.4.3 Analog Devices........................................................................149

7.4.4 Taro Pharmaceutical...............................................................150

7.4.5 Multimedia Games.................................................................151

Contents X\

8 MARKET MODELS 153

8.1 Systems Model.........................................................................1

8.2 Sentiment Model....................................................................158

8.21 Volatilit>- Index (VIX).............................................................158

8.2.2 Put/Call Ratio.........................................................................161

8.2.3 New Highs..............................................................................162

8.2.4 New Lows...............................................................................163

8.25 Anns Index (TRIN)...............................................................164

8.2.6 Bullish Consensus....................................................................165

8.2.7 Short Sales Ratio.....................................................................165

8.3 Market Trading System...........................................................167

8.3.1 Long Signal...........................................................................168

8.3.2 Short Signal.............................................................................168

8.4 Examples.................................................................................172

8.5 Data Sources...........................................................................176

9T00LS0FTHETRADE 177

9.1 Tyco Case Study......................................................................178

9.2 Preparation..............................................................................179

9.2.1 Software,.

..180

9.3 A Trading Day.........................................................................181

9.3.1 Chart Review.......................................................................186

lODAYTKNG 1»

10.1 Finding a Day Trading Firm...................................................194

10.2 Trading the Nasdaq................................................................196

10.21 Nasdaq Market Participants..

10.2.2 Level II Quotations.....................................

10.2.3 Level II Tutorial.........................................

10.2.4 Case Study: ImClone Systems.....................

10.2.5 Case Study: Comverse Technology.............

10.2.6 Case Studj: OSCA

196

......199

......201

......203



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