Chapter 8
How to Use Trading Models
The harder I work, the luckier I get.
—Anonymous
This chapter examines a wide array of positive expectancy trend- following and mean reversion trading models in hopes of expanding how readers view market behavior as well as ways of capitalizing on such idiosyncrasies. Particular emphasis is placed on models that enjoy low risk and high reward and are in the direction of the longer-term trend.
MECHANICAL TRADING SYSTEMS
Mechanical trading systems are rule-based models automated to execute trades without the discretionary input of speculators regarding entry or exit. These systems tend to focus on mathematical technical indicators—such as moving averages or oscillators—to develop objective rules of entry, risk management, and exiting with profits.
The first challenge for system developers is determining a starting point for their research. My rule of thumb for model development is that less is more. The goal is creating positive expectancy models containing the fewest parameters possible without sacrificing performance. In general, work with mathematical technical indicators that complement each other instead of those identifying the same type of market behavior. Specifically, start by building models with one trend-following indicator (like a moving average), one oscillator (such as relative strength index), one volatility indicator (like average true range), and volume. Next, traders developing models with mathematically derived technical indicators ...
