A Guide to Creating A Successful Algorithmic Trading Strategy



"This book succinctly identifies the key issues that are critical for algorithmic trading. Coming from one of the foremost trading experts, it carries the authority of experience. It belongs on the top shelf of every trader's library, where it can be reviewed from time to time to keep trading on track."
—John Ehlers, author of Cycle Analytics for Traders and President, MESA Software

"While many authors obfuscate, Perry Kaufman demystifies. For new and experienced algorithmic traders, this book maintains a steady focus on the critical elements that can drive success. In fact, the book itself follows Perry's guidelines: put the probabilities on your side, pay attention to details, and don't overcomplicate the machinery. Thank you, Perry."
—Stanley Dash, CMT, VP, Applied Technical Analysis, TradeStation®

"I have known Perry for 25 years. I have never had a conversation with him or read his writing and not taken away something of value. This new book is no exception. This is the kind of no-nonsense information from someone who has 'walked the walk' and which someone who wants to make a success of algo trading needs. Start here."
—Bob Pardo, President, Pardo Capital Limited, and author of The Evaluation and Optimization of Trading Strategies, Second Edition

"Perry is well known for his two kilo book, Trading Systems and Methods. This new book represents the other side of the coin: a short and quickly readable book that deals with the most important issues to develop a successful trading system. Readers will understand the essential concepts that every algorithmic trader must know in order to achieve their goals."
—Mario V. Guffanti, Vice President of SAMT (Swiss Association of Market Technicians)

"Perry Kaufman's basic points for system development are essential if you are going to create a successful trading system."
—Tom Aspray, Professional Trader and Analyst, Former Senior Editor,

PERRY J. KAUFMAN is a leading investment consultant with more than forty years of experience in the equity and derivatives markets. He is the author of twelve trading books, including Trading Systems and Methods, Fifth Edition; A Short Course in Technical Trading; Smarter Trading; and Global Equity Investing. Perry continues to be a pioneer in the use of computer models for making financial decisions.

Acknowledgments xi

CHAPTER 1 A Brief Introduction: The Ground Rules 1

My Objective 2

The Ground Rules 3

The Process 3

Basic Trading Systems 6

CHAPTER 2 The Idea 9

Begin at the Beginning 9

The Idea Must Match Your Trading Personality 11

I Need a Fast Payout 12

Withstanding the Test of Time 13

CHAPTER 3 Don’t Make It Complex 15

A Word about Noise 17

Integrated Solutions versus Building Blocks 18

More Rules, Fewer Opportunities, Less Success 19

CHAPTER 4 Why Should I Care about “Robust” If I’m Trading Only Apple? 21

Is It Robust? 22

Another Dimension 25

But Which Parameter Value Do I Trade? 27

Multiple Time Frames 28

Is One Trend Method Better Than Another? 29

CHAPTER 5 Less Is More 33

Volatility Cuts Both Ways 34

Bull Markets Happen When Everyone Is in Denial 36

CHAPTER 6 If You’re a Trend Follower, Don’t Use Profit-Taking or Stops 39

The Dynamics of a Trend Strategy 42

It’s Getting Harder to Find the Trend 42

The Eurodollar Trend 43

Where Do You Place Your Stop? 45

What about Profit-Taking? 46

Entering on a Pullback 47

Which Is the Best Trend-Following Method? 48

CHAPTER 7 Take Your Profit If You’re a Short-Term Trader 51

What’s Bad for the Trend Is Good for the Short-Term Trader 53

If You Can’t Use Stops for Trend Following, Can You Use Them for Short-Term Trading? 55

There Are Always Exceptions 56

CHAPTER 8 Searching for the Perfect System 59

Looking at the Results 61

How Much Data and How Many Trades Are Enough? 62

So, Which Parameter Value Do I Pick? 63

CHAPTER 9 Equal Opportunity Trading 65

Calculating Position Size 66

Avoid Low-Priced Stocks 66

True Volatility-Adjusting Doesn’t Work for a Portfolio of Stocks 67

Risk in Futures 67

Target Risk 68

Calculate the Rate of Return for the Portfolio 69

Assigning Risk to Your Portfolio 72

Multiple Strategies Are More Important 73

Not So Easy for the Institutions 75

Too Much of a Good Thing Can Be Bad 75

CHAPTER 10 Testing--The Fork in the Road 79

Let the Computer Solve It for You 81

How Do You Evaluate the Results? 83

What’s Feedback? 84

Hidden Danger 86

Forgotten History 86

Use True Costs 87

Use Dirty Data 89

Back-Adjusted and Split-Adjusted Data 91

The Different Performance Measures 92

Interpreting the Ratio 92

Not Everyone Uses the Information Ratio 93

Number of Trades 94

Expectations 94

CHAPTER 11 Beating It into Submission 97

Fixing Losing Periods 97

Use the Average Results 99

Squeezing the Life Out of a System 101

Generalizing the Rules 105

CHAPTER 12 More on Futures 107

Leverage 108

Conversion Factors for Calculating Returns 109

Don’t Forget FX 110

FX Quotes 111

Real Diversification 113

The Life Cycle of a Commodity Market 115

CHAPTER 13 I Don’t Want No Stinkin’ Risk 117

A Clear Plan 119

Avoid Low-Priced Stocks 120

Volatility Over 100%? 121

Don’t Trade When Volatility Is Very High 122

Sidestepping Price Shocks 122

Portfolio Drawdown 123

Business Risk 124

Gearing Back Up 125

CHAPTER 14 Picking the Best Stocks (and Futures Markets) for Your Portfolio 127

Asking Too Much 127

The Practical Solution 128

Ranking Success 130

Rotation 132

CHAPTER 15 Matching the Strategy to the Market 133

Noise for Stocks 134

Noise for ETFs 136

Noise for Futures 136

CHAPTER 16 Constructing a Trend Strategy 139

The Trend 140

Buying and Selling Rules 141

First Tests 141

Costs 143

Expectations 143

Satisfying the First Milestone 144

Profit-Taking 146

Volatility Filter 148

Combining Rules 149

Multiple Entries and Exits 150

More Markets, More Robustness 151

Stabilizing the Risk 152

Do It Yourself 153

CHAPTER 17 Constructing an Intraday Trading Strategy 155

The Time Frame 156

Outline 157

Deciding on the Strategy 158

Choosing a Strategy 158

Directional or Mean Reverting 159

The Basic Rules 160

The Breakout Rule 161

Profit Taking and Extreme Volatility 162

What About the Trend? 163

CHAPTER 18 Summary 167

Resources 169

System Development Platforms 169

Blogs 170

Periodicals 171

Perry Kaufman Websites 172

Index 173