Trading Systems and Methods, 6th Edition

CHAPTER 22Adding Reality

This chapter discusses topics that do not seem to fit into a clean category but are essential for trading, especially systematic trading. The first part concerns the use – and the misuse – of the computer. Technical analysis and computers have become inseparable. It would be rare to trade a new system without first running it through a computer to simulate its past performance.

“Extreme Events” discusses 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 their importance 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” looks at how Martingales would help control risk. 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?

There is a short section that looks at the characteristics and trade-offs of trend following and mean reversion strategies. It is important that your choice of trading fits your ability to take risk.

The last section reviews ...