In previous instalments of this series, I’ve provided some information on why you should build your own trading system, with the last part providing a simple trading system.

The big question for many traders is “How do I get a system that gives me an edge?”.  Following the well worn approaches of moving averages and other lagging indicators will not get you there.  You can be sure that the world’s best traders are not going over the same old ground.

I have mentioned some advanced tools and algorithms: what are they, what do you use them for and how can you easily access them?

The latest tools draw from artificial intelligence and non-linear mathematics.  You don’t need to have a degree in maths or computer science to use these.  However you do need to understand how they can help you.

I’ve already discussed the benefits of Loess smoothing in a previous article.  This is a way of getting an edge over lagging moving averages.

The first new type of tool is a genetic algorithm.  These tools use a simulation of Darwinian evolution, by generating random rules, testing their performance, retaining the best rules (survival of the fittest), then bringing these forward to the next generation and combining characteristics to continually “evolve” better rules.  The system randomly provides some mutations to see if this can lead to a better rule.

In summary, genetic algorithms generate rules from data by rapidly trying out different combinations – they are a search tool.  They are similar to Excel’s solver, but far more powerful.  Genetic algorithms don’t do anything that trying every single possible combination of inputs doesn’t do, but they are far quicker, especially as the complexity of the data increases.  Simulated annealing is a similar process.

My favourite accessible genetic algorithm tool is Pi Blue’s OptWorks for Excel.  It is very simple to use.  If you have an Excel spreadsheet, you can pretty much let OptWorks loose on it and evolve some rules.  Of course, you also need to backtest the rules against data that has not been used to build the rules.  Also, you can’t just put in a high, low, close and open, and expect a winning strategy, you need to lay out the data so that the system can find some rules.

Neural networks are often seen as a panacea for traders, but many traders don’t understand what they are and what they can do.  A neural network is a computer model of biological neurons.  It learns by modifying the connections between neurons so that the result it generates matches that from a sample set.  The benefit of a neural network is that you can give it examples, then it can learn from the examples and identify trading patterns from real life data.

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Tags: backtesting, build your own trading system, genetic algorithms, neural networks, Trading Systems

This entry was posted on Sunday, May 4th, 2008 at 1:19 pm and is filed under Trading Systems. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.