This chapter discusses areas of technical and mathematical analysis that are not systems by themselves yet are essential to the successful development of a system and to trading. The first part concerns the use—and the misuse—of the computer. Technical analysis and computers have become inseparable and, with the simple steps provided by development software such as TradeStation, MetaStock, and spreadsheets, it would be rare to trade a new technical system without first running it through a computer to simulate its past performance.
The second section, “Extreme Events,” is the most underestimated deterrent for finding the best system, for generating realistic expectations, and the most common reason for catastrophic loss. Price shocks have been discussed in Chapter 21 (“Anatomy of an Optimization”), yet they cannot be underestimated. Unpredictable events, once they become part of price history, are often treated as though they could have been anticipated. This can inflate performance returns and minimize risk during strategy testing with serious consequences to actual trading. This section tries to explain how to close the gap between testing and reality.
“Gambling Techniques—The Theory of Runs,” the third section, is actually an application of gambling techniques, primarily Martingales, to trading. What would seem more reasonable than assuming that the odds are against you in the stock or futures markets and treating it as a gambling scenario? ...