Term
| Describe the most consistent method of calculating puts to calls. (KD-TA; p. 98) |
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Definition
| Calculate a ratio of the total volume of puts traded in a day versus the total volume of calls |
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Term
| Explain what the VIX is, why is deemed to be useful and how it can be used as a sentiment indicator. (KD-TA; p. 101) |
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Definition
| The VIX is a percentage indicator of implied volatility in S&P 500 options - by looking at implied volatility rather than historical volatility, , the analyst hopes to measure anxiousness about the future. We can determine market emotion using the VIX by looking for extremes in implied volatility, for which the VIX is the most common measure. |
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Term
| Identify and describe the most reliable mutual fund statistic. (KD-TA; p.108) |
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Definition
| Cash reserves in stock mutual funds as a percentage of the assets and adjusted for interest rates. Mutual fund cash holdings are contrary indicators for the stock markets since high levels usually occur at stock market bottoms. It has been found to be particularly useful to adjust mutual fund cash by the interest rate. It is, however, only a marginal indicator of uninformed sentiment. |
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Term
| Explain the concept of Average True Range, why it is used and how it is used as a price filter. (KD-TA; p. 259) |
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Definition
| ATR is a measure of dispersion of a security's price used in many indicators as well as b/o and s/l formulas. It is calculated as the average of the True Range over some period (e.g. 14-day). True Range itself is typically the difference between the current bar high and low. We can use ATR as a price filter by adding a multiple of the ATR to the resistance line and deducting the same multiple of the ATR from the support level - this creates a dynamic range that accounts for a security's volatility. |
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Term
| Explain what the Pivot Point technique is used for and how it works. (KD-TA; p.260) |
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Definition
| Method of determining likely support and resistance levels using the previous bar's high, low and close for the current bar. The most recent bar's action is believed to be the best predictor of the current bar's action. Since the formula essentially measures the previous day's volatility, the technique's underlying logic is useful for confirming a b/o. |
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Term
| Explain how the Chandelier Exit works, what is used for and when it is particularly useful. (KD-TA; p.266) |
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Definition
| It sets protective 'trailing' stop levels using a defined multiple (usually between 2.5x and 4x) of the ATR. Since it uses the ATR, its main benefit is that it takes into account a security's intrinsic volatility and recent price action. For example, for a stock trading at $50 with a 14-day ATR of $2.50, the 3x Chandelier Exit Point becomes $42.50. It is particularly useful when other levels such as trend line or support levels are considerably distant from the current price or when the security is in an accelerated uptrend whose end is difficult to predict. |
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Term
| Explain the difference between a throwback and a pullback (KD-TA; p.303) |
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Definition
| Pullbacks occur when prices break out downward and then "pull back" to their breakout level. Throwbacks occur when prices break out upward and then "throw back" to their breakout level. |
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Term
| Define 'failure' in the context of a break-out (KD-TA; p.303) |
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Definition
| Failures occur when a break-out do not last, hence ending the possibility of a new trend forming. One definition holds that failure is when the price fails to move at least 5% in the direction of the break-out. |
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Term
| Why do we say that the standard deviation of a portfolio's return is a 'quadratic' function? |
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Definition
| Because the std. dev. is almost always less than the average of the individual std. dev. of the individual assets - there is a covariance element that needs to be accounted for |
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Term
| Suggest key drawbacks of the Sharpe ratio when applied to trading systems (KD-TA; p. 551) |
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Definition
| (1) Does not include the actual annual return but only the average monthly returns; (2) Does not distinguish between upside and downside fluctuations (i.e. assumes normal distribution); (3) Does not distinguish between intermittent and consecutive losses (i.e. systems with tendencies towards high drawdowns from consecutive losses are not deemed as risky as those with intermittent losses of little consequence) |
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Term
| Describe the 'Sterling', 'Return Retracement' and 'Treynor' ratios (KD-TA; p. 551) |
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Definition
| (1) Applied over three years, the SR is the arithmetic avg. of annual net profit divided by average annual maximum draw-down; (2) RR = average annualized compound return divided by the maximum retracement (= max(worst loss from buying at the peak, worst loss at low point from any prior point)); (3) TR = (avg. return - Rf)/Beta |
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Term
| Explain the 'Risk of Ruin' concept and some of its draw-backs. Provide the RoR formula. Finally determine the optimal percentage of capital to use in a system with 82.33% profitable trades, an avg. win amount of $231.85 and an avg. loss of $170.84. Explain what this 'optimal perecentage' means (KD-TA; p. 565) |
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Definition
| (1) The 'Risk of Ruin' formula is a method for calculatig position size for a trading system. (2) Formula fails to account for the amount of each win and loss: systems with few big winners will have higher RoR. (3) RoR = [(1-ta)/(1+ta)]^CU, where ta (trading advantage) = % probability of a win - % probability of a loss, and CU = 'contract units,' number of trading units; (4) A = Avg. Pay-off Ratio = 231.85/170.84 = 1.357. PCT = {[(A+1)xp]-1}/A. PCT = {[(1.357+1)x0.8233]-1}/1.357 = 69.3% (5) Any amount over 69.3% of capital in this system has a high chance of ending in ruin. Risking only 2% therefore has a low RoR |
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Term
| Explain the 'Optimal Percentage of Capital' concept. What is it used for? How can we use it to determine the number of contracts or shares to buy for a trade (i.e. provide the formula for calculating optimal number of contracts or shares using the OPC concept)? (KD - TA; p. 567) |
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Definition
| PCT = {[(A+1)*p]-1}/A, where A = avg. pay-off ratio (avg. win size/avg. loss size), p = % of wins, PCT = % of capital to use. We use it to determine the optimum % of capital to use with a system in order to avoid the risk of ruin. (PCT * Capital)/margin requirement = 'optimal' number of contracts; (PCT * Capital)/share price = 'optimal' number of shares |
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Term
| Define ‘population parameter.’ Explain it in the context of a technical analysis system and suggest what assumption is made with regards to it (DA –EBTA; p. 188) |
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Definition
| Fact or characteristic about the population that we would like to know. It is unknown or unknowable because the entire population cannot be observed. In the case of a TA rule, the population parameter is the rule’s expected performance over the immediate practical future. We assume that it is equal to 0 (i.e. the tested rule has no predictive power) |
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Term
| Explain the importance of a sample statistic and what is meant by a statistical inference. How are these related to sampling variability? How can we determine the 'relevance' of the sample statistic with respect to sampling variability? (DA – EBTA; p.189) |
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Definition
| The SS sheds light on the population parameter. The SI is the inductive leap from the observed value of a sample statistic to the value of the population parameter (known vs. unknown). If the positive performance (SS) is consistently too high to be reasonably attributed to sampling variability, the reasonable SI is that the rule possesses genuine predictive power and a positive expected return - hence, we can say that the sample statistic is 'relevant' if the positive performance is too high to be attributed to sampling variability |
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Term
| Define standard deviation and write out the formula (DA – EBTA; p. 192) |
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Definition
| The square root of the average squared deviations of each observation from the mean of the data. |
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Term
| Define a probability density function is (DA – EBTA; p. 200) |
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Definition
| A relative frequency distribution built from an infinite number of observations and intervals of zero width. |
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Term
| Explain the common concern of both hypothesis testing and parameter estimation and distinguish between the two (DA – EBTA; p. 217) |
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Definition
| Both are concerned with the unknown value of a population parameter. A hypothesis test tells us if an effect is present or not, whereas an estimate tells us about the size of an effect |
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Term
| Explain the two components of a parameter estimate. Which of the two is more informative? Why? (DA – EBTA; p.218) |
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Definition
| Point Estimate: “The rule’s return is 10%”; Interval Estimate: “There is a 95% probability that this return falls within the range of 5% and 15%”. The latter is more informative. This is because the point estimate has limited value because it conveys no sense of the uncertainty in the estimate due to sampling error. The confidence interval solves this problem by combining the information of the point estimate with the information about the estimator's sampling distribution. |
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Term
| What are the two crucial properties the null and alternative hypotheses must possess? (DA – EBTA; p. 222) |
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Definition
| They must be mutually exclusive and exhaustive – when taken together, they cover all possibilities (e.g. a rule has an expected return greater than 0 or it does not) |
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Term
| Identify and explain each of the ‘ingredients’ required for hypothesis testing (DA – EBTA; p. 228) |
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Definition
| (1) A null hypothesis, that the rule has an expected return of 0 or less; (2) the test (sample) statistic: the rule’s mean return obtained by back testing it in a historical sample of data; (3) the sampling distribution, which represents the random variation of the rule’s mean return if it were to be tested in many independent samples |
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Term
| Distinguish between type I and type II errors. Which is more serious? (DA – EBTA; p. 233) |
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Definition
| Type I: When a low p-value leads us to reject H0 when it is in fact true. Type II: When the p-value is not low enough for us to reject H0, but H0 is in fact false. Type I is more serious since we are actually exposing the capital to risk to a rule that in reality does not have predictive power |
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Term
| What is the point of generating a sampling distribution? (DA – EBTA; p.234) |
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Definition
| Estimating the shape of the sampling distribution for the test statistic allows us to estimate the degree of random variation in a test statistic when there is only a single sample of data. |
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Term
| Explain the commonality and differences between the two computer intensive methods for generating the sampling distribution (DA – EBTA; p. 235) |
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Definition
| Both the bootstrapping and monte carlo methods randomly resample (reuse) the original sample of observations to produce new computer-generated samples. They differ in that (1) each method tests different versions of the null hypothesis, and therefore require different data; (2) they use different random sampling methods – one with replacement (bootstrapping) the other without (MC) |
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Term
| Explain the criteria used to judge the quality of an estimator (DA – EBTA; p. 244) |
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Definition
| C*U*E*S: (1) Consistent: Value converges to the value of the population parameter as sample size is increased; (2) Unbiased: The expected value of the estimator = population value (deviations have an average value of 0); (3) Efficient: Produces the narrowest sampling distribution – has the smallest standard error; (4) Sufficient: Other estimators would not add information about the parameter being estimated |
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Term
| Distinguish between descriptive and inferential statistics (KD – TA; p.583) |
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Definition
| Descriptive: Describes or characterizes a data set (i.e. describes something). Inferential: Uses observations as a basis for making estimates or predictions (i.e. makes inferences about a situation that has not yet been observed). |
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Term
| Suggest some common measures of dispersion and their drawbacks. |
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Definition
| (1) Range: difference between max and min. values in a sample (does not say how close the observations are to the mean and median); (2) Variance: average of the squared differences between each observation of a sample and the mean of that sample (measures dispersion about the mean rather than spread or dispersion); (3) Standard Deviation: positive square root of the variance (standardized measure from the mean); (4) Degrees of Freedom: Used with values derived from a sample rather than a population (i.e. we use n-1 in the denominator rather than n in order to get an unbiased estimate). Provides a bigger margin of error |
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Term
| Explain the relationship between the t statistic and P values (KD – TA; p.594) |
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Definition
| The p value states the probability that the t value occurred by chance alone - hence, we need to have low p values (usually less than 5%). For the t statistic itself to be significant, we require a value greater than 2 |
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Term
| Describe some common distributions. What is each used for? |
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Definition
| (1) Chi-square distribution: based on the sum of standard normal variables - the more standard variables (i.e. DoF), the more it resembles a normal distribution. Used primarily for goodness-of-fit tests; (2) Student's T distribution: applies when the true standard deviation is unknown and for small samples. It has wider tails than the normal distribution; (3) F distribution: based on the ratio of two variables, each of which follow a Chi distribution |
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Term
| Suggest what is meant by a 'stationary' time series and whether stock prices and returns are stationary. How do we test for 'stationarity,' what hypothesis would we use and what do we conclude if we reject the hypothesis? (KD - TA; p. 602) |
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Definition
| Stationary time series are generally stable, with a degree of structure. Stock prices are usually nonstationary (because they trend up and down) but returns are often stationary. We test for stationarity using a unit root test, with the hypothesis that the series has a unit root (i.e. it is not stationary). If the series does not have a unit root, we reject the hypothesis and conclude that the series is indeed stationary |
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Term
| What are ARCH and GARCH methods used for? Suggest three reasons why this pursuit is useful (KD – TA; p. 602) |
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Definition
| To estimate volatility. Volatility estimates are useful because of (i) the increased use of options contracts, and the fact that volatility is a key input into option pricing models; (ii) frequency of high volatility periods; (iii) increased use of VaR, which requires vol. estimates |
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Term
| In the context of cycle analysis, define: amplitude, period, summation, inversion, harmonics |
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Definition
| (1) Distance from the horizontal axis to the extreme peak or trough; (2) Distance between consecutive lows or highs; (3) Calculating multiple cosine waves and adding them together; (4) Where a cycle low is expected, a peak occurs instead; (5)Cycles tend to have period lengths a multiple of two or three longer or shorter than the next larger or smaller cycles (e.g. a cycle of 20 days will indicate that another longer cycle of either 40- or 60-days length exists as well as shorter cycles of 7 or 10 days) |
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Term
| What is an 'asymmetric filter' within the context of point & figure charts? |
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Definition
| This refers to the way in which 'multiple reversal' charts (e.g. 2-box reversal, 3-box reversal, etc.) require only one point move to mark a new box within the prevailing trend but require a multiple point movement in the opposite direction to begin illustrating the reversal. Hence, it keeps traders focused on the primary or main trend for longer since it is less sensitive to short-term reactions to the main trend |
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Term
| Explain the difference between 'semi-catapults' and 'fulcrums' in P&F charts. |
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Definition
| In 1-box charts, continuation patterns are called 'semi-catapults' but reversal patterns are called 'fulcrums' |
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Term
| What is the difference between a trap and a shakeout on P&F charts? |
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Definition
| Shakeouts occur at the start of a new trend, usually a bull trend. Since it is the first sell in a bull trend, it is recommended to ignore this reaction and view it as a sign of strength (as long as it does not break below the trend line) |
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Term
| What is a 'pole' in the context of P&F charts? What is peculiar about it relative to other 3-box patterns? When do they occur? How can you identify an 'effective' pole? |
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Definition
| A long column of Xs or Os with a column of Os or Xs beside it. They are reversal patterns, never continuation. They occur when prices break above/below previous price action and result in a long column of Xs or Os. Effective ones will have 5 or more boxes in height |
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Term
| What is a common strategy for trading 'poles' on a P&F chart? |
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Definition
| To sell when the reversal column (of Os, for example) retraces 50% of the previous column's length. |
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Term
| Explain what poles are. Distinguish between 'high poles' and 'low poles' in P&F charts. When do high poles usually occur? (JdP - DGPF; p. 155) |
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Definition
| Poles are a long column of Xs or Os with a column of Os or Xs alongside it; they are reversal patterns, never continuation patterns. The b/o with the first column should exceed the previous highs or lows by at least 5 boxes (smaller excess = greater chance of pattern failure). The second column must then retrace the previous b/o by more than 50%. Retracement is necessary for the completion of the pole. (1) A high poles starts with a column of Xs, and indicates near-term weakness. These usually occur at the end of an up-trend. (2) A low poles indicates near-term strength. |
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Term
| What does 'translation' refer to in terms of cycles and what is the difference between a right and left translation? |
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Definition
| Translation describes where the peak of a cycle falls in regards to the midpoint. A "right" translation is bullish and appears in a cycle is when the peak occurs after the expected halfway point. A "left" translation is bearish, and occurs when the cycle peak occurs before the halfway point. (= left is early, right is late) |
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Term
| What does the typical wave structure in Elliott Wave theory look like? |
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Definition
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Term
| List the Three Key Rules of Elliott Waves. |
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Definition
| (1) Wave 2 cannot retrace more than 100% of Wave 1; (2) Wave 3 can never be the shortest; (3) Wave 4 never ends in the price territory of Wave 1. |
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Term
| Describe the three Elliott Wave 'guidelines' (KD - TA; p. 487) |
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Definition
| A*C*E (1) Alternation: If wave 2 is sharp, wave 4 will be sideways (if 2 is sideways, 4 will be sharp); (2) Equality: When wave 3 is the longest wave, waves 5 and 1 will be equal; (3) Channeling: Correction following wave 5 will end within the price action of wave 4 (i.e. support will be at the lowest level marked by wave 4) |
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Term
| Suggest some basic characteristics of Wave 1 (FP - EWP; p. 77) |
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Definition
| (1) Heavily corrected by Wave 2; (2) Lots of short selling (crowd "convinced" trend remains down); (3) Technically more constructive than past bear market rallies (breadth and volume increase, accumulation beginning); (4) First wave is ugly |
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Term
| Suggest some basic characteristics of Wave 2 (FP - EWP; p. 78) |
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Definition
| (1) Erodes much of the Wave 1 advance; (2) Crowd convinced that the "bear is back" ('one last chance to sell'); (3) Often ends on low volume |
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Term
| Suggest some basic characteristics of Wave 3 (FP - EWP; p. 80) |
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Definition
| (1) Strong and bold; (2) Breakouts on significant volume; (3) Continuation gaps possible; (4) Expanding breadth; (5) Increasingly favourable fundamentals, investor confidence returns; (6) Holds the most valuable keys to the price action's 'personality' |
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Term
| Suggest some basic characteristics of Wave 4 |
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Definition
| (1) Predictable in depth and form (use Wave 2 as a reference); (2) Most often a sideways move due to Wave 3 strength; (3) Initial deterioration sets the scene for non-confirmations of new highs in Wave 5 |
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Term
| Suggest some basic characteristics of Wave 5. |
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Definition
| (1) Less dynamic than other waves; (2) Lower breadth, declining volume; (3) Will have price targets based on Waves 3 & 4 |
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Term
| Draw and label an Idealized Elliott Wave Progression, describing the characteristics of each component. Labels should reflect the characteristic of each wave. |
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Definition
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Term
| Draw and label an Idealized Corrective Wave's progression, describing the characteristics of each component. Labels should reflect the characteristic of each wave. |
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Definition
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Term
| Describe the different categories of corrections. Where possible, comment on where you might see a particular type of correction (FP - EWP; p. 41) |
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Definition
| (1) Zig Zags: Can take the 1-1-1 form or the 5-3-5 formation (often in Wave 2, rarely in Wave 4). Exist as single, double or triple zig-zags; (2) Flat: A choppy, sideways correction. Occurs when the overall trend is strong, frequently in Wave 4 of an Impulse. Likely to retrace less than a typical zig zag. Types include regular, expanded and running; (3) Triangle: 5 legged move that is a coiling, sideways correction. Each leg is made up of 3 sub-waves. Will most likely occur in Wave 4 or B. Types include contracting, barrier and expanding |
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Term
| Illustrate how you would derive a breakout target from a triangle correction according to EWT. |
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Definition
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Term
| Illustrate what is meant by "Channeling" and explain its implications in reference to the additional guidelines of EWT |
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Definition
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Term
| Explain the importance of volume & other secondary indicators in the context of EWT. |
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Definition
| Volume is key in determining "termination" of certain waves: (1) corrective waves (incl. Wave 2 and 4) end on lower volume; (2) Wave 5 ends on lower Volume (linked to negative divergence). Other secondary methods can be used in the context of negative divergences, confirmations, etc. |
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Term
| Illustrate how you would derive a price target for a corrective sequence for EWT using Fibonacci retracements |
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Definition
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Term
| Illustrate how you would derive upside price targets for EWT using Fibonacci numbers |
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Definition
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Term
| Suggest different practical methods of determining Cycles |
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Definition
| (1) Counting/Observation: Naked eye; (2) Detrending: Subtract average from actual values then divide by the average (can become erratic and difficult to interpret); (3) Centred Moving Average: Average should be placd at the time "mid-point" of the period being measured (only measures, doesn't predict cycles); (4) Envelopes: Uses envelopes of differing time periods to determine cycles of greater and lesser degree |
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Term
| Suggest three methods for period projection using cycles. What is needed to do this? (KD - TA; p. 468) |
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Definition
| (1) Measuring by hand; (2) Standard charting tools; (3) Linear Regression (preferred method). To employ these methods, we need the period, standard error and an ideal starting point |
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Term
| List the main characteristics of the Kondratieff Wave. |
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Definition
| 50-54 years in duration: each wave has three phases (up wave of 20 years, transition/plateau of 7-10 years, down wave of 20 years); wars are associated with the beginning & ending of each wave (trough war and peak war) |
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Term
| Describe the implications suggested by the four-year cycle. |
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Definition
| Coincides with the elected term of US presidents. Election year (normally quite strong for equity markets). Years 2 & 3 are usually weak. Pre-election year normally quite strong. |
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Term
| Suggest differences between a hanging man and hammer patterns (SN - JCCP; 34) |
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Definition
| (1) Hammer must come after a decline, HM after a rally; (2) Hammer is valid even if it comes after a short-term decline, but a HM should emerge after an extended rally; (3) A HM should be confirmed, but not a H. |
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Term
| Suggest some factors that may increase the likelihood that an engulfing pattern could be an important turning signal (SN - JCCP; p. 43). |
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Definition
| (1) The first day has a very small real body (reflects dissipation of prior trend's force) and the second day has a very long one (increase in force behind the new move); (2) The EP appears after a protracted or very fast move; (3) There is heavy volume on the second real body |
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Term
| Distinguish between a dark cloud cover and a piercing line (SN - JCCP; p. 49) |
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Definition
| Both are two-day candlestick reversal patterns. (1) DCC occurs when the second candle opens higher than the first but closes lower - it is a bearish pattern; (2) PL occurs when the second candle opens lower than the first but closes higher (at least 50% into the first candle) - it is a bullish pattern |
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Term
| Draw examples of Piercing Line & Dark Cloud Cover patterns (SN - JCCP; p. 55) |
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Definition
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Term
| Explain what stars are and illustrate morning and evening star formations, noting important components of the formation (SN - JCCP; p. 62) |
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Definition
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Term
| Illustrate inverted hammers and shooting stars, suggesting comments on how to gauge their significance (SN - JCCP; p. 74) |
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Definition
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Term
| Distinguish between bullish and bearish haramis (SN - JCCP; p. 82). |
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Definition
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Term
| Explain what 'tweezer tops' and 'tweezer bottoms' are, mentioning important criteria for identifying such formations. Suggest some examples (SN - JCCP; p. 89) |
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Definition
| Tweezers occur when two consecutive candles have the same high or low. A key requirement for a tweezer top or bottom is that the first candle should be long, with the second one often being shorter. For example, we can have a Tweezer Top + Harami Cross formation, or a Tweezer Top + Inverted Hammer formation. |
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Term
| Explain what is meant by a high-price gapping play and the implications of such a pattern (SN – JCCP; p. 136) |
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Definition
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Term
| Describe what a 'Rising Three Methods' pattern looks like and explain its significance. Which Western pattern does it most closely resemble and what exceptions are allowed in its identification? (SN - JCCP; p. 142) |
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Definition
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Term
| Explain the concept of money velocity. How is it calculated? What is the relation to inflation? What is the relation to stock prices? |
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Definition
| Money Velocity (MV) measurse how fast money turns over in the economy. MV = (personal income)/(M2). Historically, MV is positively related to inflation since the faster money circulates, the more pressure exists on prices. Relative to stock prices, when MV (a monthly figure) rises above its 13-month MA, stock markets rise slower than when it declines below its 13-month MA (i.e. inflationary pressure dampens stock market prices) |
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Term
| What does a 'one-step-back' refer to in point and figure charting? How could it be a significant signal? |
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Definition
| One-step-back allows us to plot opposite signals in the same column when there is a one-box reversal in a new column. For example, if we have just started a new column with a O (i.e. there has been a one-box reversal from a column of Xs), we can draw an X immediately above the O in the same column rather than start a new column. It may signal a start to a correction, and is therefore significant |
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Term
| What are the three main tools available to the US Federal Reserve for adjusting the money supply? Which one is used most often? |
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Definition
| (1) Changing the amount of reserves that banks are required to hold; (2) Changing the discount rate; (3) Buying and selling US Treasury and federal agency securities through open market operations. Open market operations are used most often |
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Term
| What is the federal funds rate target? How does the Federal Reserve try to achieve its target? Who determines it? |
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Definition
| It is the interest rate at which banks borrow from each other. The Fed uses open market operations to reach it. It is determined by the Federal Open Market Committee (FOMC) when they meet every six weeks |
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Term
| Suggest some false notions about market efficiency (DA - EBTA; p. 337) |
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Definition
| (1) Market efficiency simply requires that price deviates from the rational value in an unbiased fashion - it does not dictate that the market price will equal the rational value at all times; (2) It does not imply that no one can beat the market - at any given time period, about 50% of investors will be outperforming the benchmark |
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Term
| Explain the 'cost of information' paradox related to EMH (DA - EBTA; p. 343) |
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Definition
| EMH requires that information seekers be compensated for the efforts and simultaneously denies that they will be. If EMH suggests there is no payoff for information gathering and processing, then it also implies that no one would dig out the information and act on it so that it may be reflected in the price |
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Term
| Identify the main assumptions of EMH and suggest reasons as to why they may be flawed (DA - EBTA; p. 345) |
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Definition
| (1) Investors are rational: many investors react to irrelevant information ('noise signals'), fail to diversify, trade too actively and have other recurring failures; (2) Investor errors 'are uncorrelated' (cancel out): most people tend to make similar mistakes in times of uncertainty, making deviations from rationality correlated; (3) Arbitrage forces prices to rational levels: improper use of leverage (LTCM), lack of perfect substitutes, limted power of arbitrage activities (i.e. impossible to truly 'mispriced' securities, limited tolerance for adverse price movements, limited funds/mandate, etc.) |
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Term
| Define 'noise trader risk' and explain its significance (DA - EBTA; p. 347) |
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Definition
| When noise traders drive rational investors out of business by driving prices further away from rational prices. For example, if an arbitrageur spots and buys a security he believes is underpriced, but the price continues to fall even further, he is likely to eventually close the position with a loss. It limits the motivation and commitment of arbitrage traders |
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Term
| What is the significance of combining the pillars of behavioural finance? Identify and explain these pillars (DA - EBTA; p. 356) |
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Definition
| Combining the pillars enables BF to predict specific departures from market efficiency that produce systematic price movements. (1) Limited ability of arbitrage to correct pricing errors: Prices cannot always react to new information because constraints on arbitrageurs limit their ability to act on the new information; (2) Limits of human rationality: Tells us under which circumstances markets are more likely to underreact to new information that overreact (and vice versa); human judgement tends to err in predictable ways when under conditions of uncertainty |
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Term
| Identify the similarities and differences between BF and EMH (DA - EBTA; p. 357) |
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Definition
| (1) Similar: both contend tht the market eventually gets it right. (2) Different: they differ about the character of these departures ad their duration: EMH says prices depart from rational levels randomly and briefly, BF says some departures are systematic and last long enough to be exploited by certain investment strategies |
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Term
| Succinctly explain what is meant by the 'crime of small numbers' and suggest the potential consequences of this act and under what circumstnances they should occur (DA - EBTA; p. 361) |
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Definition
| Crime of small numbers = sample size neglect (i.e. deriving a conclusion from too small a sample of events). Consequences: (1) Gambler's fallacy: the false expectation of a reversal due to statistical naivety (occurs when the investor holds the prior belief that a string of price changes is random); (2) Clustering illusion: misperception of order (non-randomness) in data that is actually random (occurs when the investor has no prior belief about the randomness of the process) |
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Term
| How is On Balance Volume calculated and what does it show? |
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Definition
| OBV starts with an arbitrary number, which rises and falls depending on what the price does. The volume for the day is added in when price rises and subtracted when it falls. It is plotted as a continuous line, and therefore offers a rough approximation of buying and selling pressure |
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Term
| How is the Arms Index calculated? What type of data is used? What does a higher level of the Arms Index indicate and when does the Index peak? |
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Definition
| By dividing the ratio of advancing and declining stocks by the ratio of volume in advancing issues over volume of declining issues. Daily data is used. A higher level indicates that 'the number of advancing issues is rising' on low volume. It peaks at market bottoms |
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Term
| What is the primary value of the Wave Principle? Identify & describe the modes of wave development? (FP - EWP; p. 19 & 21) |
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Definition
| To provide context for Market Analysis. This context provides both a basis for disciplined thinking and a perspective on the market's general position and outlook. The wave modes are (i) motive (5-wave structure) and (ii) corrective (3-wave structure) |
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Term
| Describe 'motive' waves and stating its 'goal' and some basic rules regarding their identification (FP - EWP; p. 30) |
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Definition
| MWs subdivide into five waves and always move in the same direction as the trend of one larger degree. Its goal is to make progress - the rules assure that it will. Rules: (1) Wave 2 always retraces less than 100% of wave 1; (2) wave 4 always retraces less than 100% of wave 3; (3) wave 3 always travels beyond the end of wave 1 |
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Term
| Define an impulse wave and suggest one rule regarding its identification. Also, define what is meant by an 'extension' (FP - EWP; p. 30) |
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Definition
| The most common of two types of motive waves (the other being diagonal). Wave 4 does not 'overlap' with wave 1 (for cash markets and except for an intra-day basis in futures). An 'extension' is an elongated impulse with exaggerated subdivisions. The majority of impulses contain (only) one in one of their three actionary subwaves |
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Term
| Explain what is meant by 'truncation' and illustrate a bull market truncation (FP - EWP; p. 35) |
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Definition
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Term
| What is the single most important rule regarding corrective waves? What are the two styles in which they come? (FP - EWP; p. 41) |
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Definition
| CWs are never 5s; only motive waves are 5s. An initial 5-wave move against the larger trend is not the end of a corrective wave, but part of one. Two styles: (i) Sharp: angle steeply against the larger trend, and (ii) Sideways: typically contain a movement that carries back to or beyond its starting level (thus producing an overall sideways appearance) |
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Term
| Explain what counterattack lines are (SN - JCCP; p. 109) |
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Definition
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Term
| Suggest different factors that would increase the likelihood of a reversal signalled by a doji (SN - JCCP; p. 155) |
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Definition
| (1) Subsequent candles confirm the doji's reversal potential; (2) Market is overbought or oversold; (3) Market doesn't have many doji (the more doji on a chart, the less meaningful each new one becomes) |
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Term
| Distinguish between and explain the significance of: long-legged doji, gravestone doji, dragonfly doji (SN - JCCP; p. 162) |
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Definition
| (1) Long-legged: long upper and lower shadows. Shows the market is separating from its trend/at a transition point/is confused; (2) Gravestone: open, low and close are the same; is a bearish signal that is strong at calling tops (considered the 'ultimate shooting star'); (3) Dragonfly: open = high = close; bullish counterpart of the gravestone |
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Term
| Explain and illustrate dumpling tops and frying pan bottoms (SN - JCCP; p. 114) |
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Definition
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Term
| Explain what is the significance of transitional phases to market technicians and how they are signaled in the markets? (MP - TAE; p. 64) |
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Definition
| The TP has great significance because it marks the turning point between rising and falling markets. They are almost invariably signaled by clearly definable price patterns or formations. |
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Term
| Explain how a ratio scale works (MP - TAE; p. 69) |
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Definition
| Prices plotted on a ratio scale show identical distances for identical percentage moves. If the distance between 1 and 2 (2:1) is 1/2 inch, then the distance between 2 and 4, 4 and 8, etc. (2:1) will also be 1/2 inch. A specific vertical distance on the chart indicates the same percentage change in the price being measured, whatever the level |
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Term
| During the formation of a price pattern, the direction of the breakout is not known. What direction should you therefore expect the breakout to be in? |
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Definition
| The price will break in the direction of the prevailing trend. It should always be assumed that the prevailing trend is intact until the weight of the evidence proves otherwise |
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Term
| What are the most important determinants of the significance of a price pattern? (MP - TAE; p. 66) |
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Definition
| Its size and depth. The longer a pattern takes to complete and the greater the price fluctuations within it, the more substantial the following move is likely to be |
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Term
| Explain the difference in the measuring implication for a consolidation rectangle and a reversal rectangle of equal depth |
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Definition
| None - the measuring objective is based on the depth. Since depth is equal, they will have same price objective |
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Term
| Suggest some factors that help determine the validity of a break-out. Separately, suggest factors that may affect the significance of a break-out. |
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Definition
| Validity: (1) volatility of the security; (2) if the b/o holds for more than 2 sessions. Significance: (1) Timeframe: the longer the timeframe (e.g. weekly vs. daily chart), the more significant the b/o (if it remains valid) |
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Term
| Draw and list the components of a head and shoulders breakout top. List the defining characteristics with respect to volume. (MP - TAE; p. 76) |
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Definition
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Term
| The volume level during the formation of the second top and second bottom in a double top and double bottom formation should be ... |
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Definition
| Less volume on both instances than the initial top or bottom |
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Term
| What is the most important point regarding group rotation? Suggest some useful functions of the theory of group rotation. (MP - TAE; p. 352) |
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Definition
| Impact of Deflation and Inflation: Deflationary forces predominate during the early stages of the cycle, whereas inflationary pressures rising as the recovery matures. Useful functions: (1) can provide a framework within which to assess the maturity of a primary trend; (2) it is helpful in determining which groups, and therefore which stocks, should be purchased or pared back |
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Term
| Explain how economic recoveries are linked to group rotation theory. List the groups tend to lead and lag at peaks and troughs (MP - TAE; p. 356) |
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Definition
| (1) Economic recoveries are typically led by consumer spending, which is spearheaded by the housing industry. As interest rates fall during a recession, demand for housing gradually picks up - homebuilders & construction stocks therefore tend to have leading tendencies. (2) Interest sensitive groups (incl. telephones, utilities, insurance, S&L, consumer finance, etc.) have a tendency to lead at peaks and troughs. Corporations with profits that are enhanced by increased capital spending or commodity price inflation generally lag the overall market. Retail stores, restaurants, cosmetics tobacco and so forth also show leading tendencies |
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Term
| List the industries that tend to lead and lag recoveries (MP - TAE; p. 363) |
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Definition
| Leaders: Utilities, financials, REITs, homebuilders, containers and packaging, consumer non-durables, transports. Laggards: Mining, Oil, Coal, Oil Drillers, Tech, Basic Industry (paper, chemicals, steel producers, etc.) |
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Term
| Identify and explain the principle concern of time in the context of longer-term cycles (MP - TAE; p. 364) |
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Definition
| Time is concerned with adjustment - the longer a trend takes to complete, the greater its psychological acceptance and the greater the necessity for prices to move in the opposite direction and adjust accordingly. For example, the 8-year bull market between 1921 and 1929 necessitated a sharp and lengthy decline to erase the amount of excesses, confidence and speculation that had built up |
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Term
| What is the most important influence on the economy and equity prices? Also, suggest reasons different reasons why interest rates affect the stock market (MP - TAE; p. 465) |
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Definition
| The rate of change of short-term interest rates. Reasons for impact: (1) Fluctuations in the price charge for credit have a major influence on the level of economic activity, and thus corporate profits; (2) Interest charges affect the bottom line and thus the price investors will pay for equities; (3) They alter the relationship between competing financial assets (bonds vs. stocks); (4) Changes in the cost of carry affect investors' desire to make purchases on margin |
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Term
| Suggest some advantages of using mechanical trading systems (MP - TAE; p. 540) |
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Definition
| (1) Removes emotion and prejudice; (2) Only require discipline to follow the system; (3) May give greater consistency of profits than a discretionary system; (4) Lets profits run; (5) Well-designed models enable participation in the direction of every important trend |
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Term
| Explain why it is important to design a mechanical trading system 'precisely' (MP - TAE; p. 541) |
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Definition
| (1) Can help remove all possible involvement of subjectivity; (2) Ensures that for every buy signal, there is a sell signal - otherwise, there could be significant losses |
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Term
| Explain the reversal sizes that short, medium and long-term term traders are likely to choose, stating the assumed time horizons in your answer (JdP - DGPF; p. 274) |
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Definition
| Short-term trader (hours to a few weeks): Should always include 1-box reversal charts as well as 3-box, perhaps even 2-box. 1-box charts (constructed using tick data, ideally) are essential for seeing support and resistance levels, and where most of the price activity is taking place. 3-box is for understanding the trend. Medium-term (1 to 6 months): 3-box charts as their objective is to stay in the trend and not get shaken out. 1-box reversals may also be used. Long-term (+6months): Almost certainly use 3-box, and may use 5-box (rare). Will never use 1-box |
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Term
| Explain the two stages to a vertical count in P&F charts (JdP - DGPF; p. 228) |
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Definition
| (1) Establishment stage: occurs when the length of the column being counted is fixed by the addition of a new column in the opposite direction - the count can then be performed and a target established; (2) Activation stage: Count and target cannot be considerd active until there has been a break above the highest X in the counting column or a break below the lowest O. Activation does not have to be the next column of Xs, but it must be within the same pattern |
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Term
| Describe 'bullish' and 'bearish' catapults. Draw a bullish catapult and suggest some rules for their identification (JdP - DGPF; p. 136) |
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Definition
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Term
| Suggest some ways in which the analysis of 1-box reversal charts differs from the analysis of 3-box reversal charts (JdP - DGPF; p. 312) |
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Definition
| (1) 45 degree trend lines have little validity - most trend lines are drawn subjectively; (2) double-top and double-bottom signals in the 3-box sense have no validity - you instead look for semi-catapults (continuation) and catapults from fulcrums (reversal); (3) vertical counts are not possible, and horizontal counts tend to give a short-term view |
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Term
| By drawing an example, explain what defines a semi-catapult pattern and, coincidentally, adds to its strength as a 'strong buy/sell' pattern (JdP - DGPF; p. 121) |
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Definition
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Term
| Explain how a valid trend-line break occurs with P&F charts (JdP - DGPF; p. 177) |
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Definition
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Term
| Explain how objective and subjective trend-lines are drawn on P&F charts (JdP - DGPF; p. 178) |
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Definition
| Objective (3-box mainly): Bullish (bearish) support (resistance) lines are drawn at 45 degrees diagonally through the corners of the square below (above) an important low (high), connecting higher lows (lower highs). Once a bullish support line is broken (confirmed by a double-bottom sell signal), a new 45 degree downtrend line is drawn; Subjective (1-box mainly): Require a reaction point after a trend has started |
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Term
| Suggest some important rules for using trend lines and signal rules in P&F chart analysis (JdP - DGPF; p. 192) |
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Definition
| (1) PF buy signals generated above an uptrend line can be considered good for opening a long or adding to an existing position; (2) PF sell signals generated above an uptrend line should be used to close or reduce a long position, not for going short; (3) PF sell signals generated below any downtrend line can be considered good for opening a short or adding to existing shorts; (4) PF buy signals generated below a downtrend line should be used to close an open short position, not for going long |
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Term
| Explain how a horizontal count is established on a 1-box reversal chart (JdP - DGPF; p. 208) |
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Definition
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Term
| Explain how a vertical count is performed on a P&F chart (JdP - DGPF; p. 221) |
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Definition
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Term
| Suggest some important points regarding P&F price targets. In particular, note how a count (vertical or otherwise) may be negated/cancelled, and what is the implication of negation (JdP - DGFP; p. 237) |
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Definition
| (1) Targets have no time-scale for their achievement; (2) Nearest counts must be achieved first before considering higher upside targets; (3) Clustering counts increases the likelihood that a target within the cluster area will be achieved; (4) A vertical upside count is negated when price falls below the anchoring low for thatcount. Negation shows weakness in the direction of that count; (5) Validity enhanced by trend lines, especially 45 degree ones (e.g. an upside count is more likely to be achieved if it occurs when the count column is above a 45 degree bullish support line); (6) Counts work better on some instruments than others |
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Term
| List the steps for obtaining a vertical count using a log scale chart and comment on the accuracy of counts on log scale charts. For example, provide a price target given the following data: 17 Xs confirmed, 1% box size, 3 box reversal chart, lowest O in previous column = 778.03 (JdP - DGPF; p. 249) |
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Definition
| (1) Count the number of boxes in the vertical column; (2) Obtain the 'extension' = multiply number of boxes by the reversal size and natural log (ln) of the box size (e.g. ln(1.01) for a 1% box size); (3) Take the ln of the anchor point; (4) Calculate the exponential (e^) of the sum of (2) and (3). Log scale counts tend to overstate both the downside and upside targets. Example answer = approx. 1,291 |
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Term
| Explain how a risk-reward ratio is derived in P&F charts (JdP - DGPF; p. 251) |
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Definition
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Term
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Definition
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Term
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Definition
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Term
| Explain why Relative Strength works well with PF charts. Suggest if there anything special needs to be done with PF analysis of RS charts relative to the analysis of PF charts of price (JdP - DGPF; p. 339) |
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Definition
| Scaling is irrelevant for RS - what is important is the trend. PF shows and defines trend better than any other chart. For example, 45 degree trend lines on 3-box PF charts define the main up and down trends objectively. PF charts of RS are analysed exactly the same way as PF charts of price. In general, log scale RS charts using a 1% box size are the most effective. 1-box reversal charts are also effective |
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Term
| Explain the benefits and limitations of optimisation for PF charts (JdP - DGPF; p. 374) |
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Definition
| (1) Optimisation provides the parameters to get the analyst started, from which point subjective analysis and knowledge of PF charts take over and adjustments are made. (2) Optimisation guides you to the best paraters to use, based on past performance - it can suggest whether an instrument's characteristics require the high/low construction rather than close only, what box size to start with, etc. (3) Optimisation is only of value with 3-box reversal charts because of their unambiguous signals; (4) % box sizes should be used unless you are looking very short-term |
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Term
| For trend-based trading systems, suggest a suitable action for potentially improving the profitability of a system and identify the major determinant of trading activity |
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Definition
| (1) Increasing the delay in taking action after a trade signal is given can help improve profitability; (2) Selection of trend speed is the major determinant of trading activity |
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Term
| Suggest what time frame is best for employing Relative Strength analysis and explain why. Also, explain the most effective way for using RS analysis (MP - TAE; p. 306 & 308) |
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Definition
| (1) Since RS trends tend to experience more random noise than absoute price trends, we generally find that charts based on weekly and monthly data tned to be more reliable than those constructed with RS daily data; (2) Construct trendlines against the RS line, wait for a violation (and then) look for a legitimate trend reversal in the price itself to act as confirmation (doesn't happen often, but is powerful) |
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Term
| Explain the basic mechanics of a typical peak, commenting on breadth and the relative fortunes of early & late cycle leaders (MP - TAE; p. 527) |
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Definition
| (1) As the top begins, liquidity-driven issues peak out and begin their bear market; (2) Late-cycle leaders are still in the terminal stages of a bull market and are helping to push the averages higher; (3) Breadth divergences tend to be prevalent at market peaks because of strength in the earnings-driven sectors outweighing weakness elsewhere (e.g. commodity boom in 1973, tech stocks in 2000) |
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Term
| Suggest typical defining stages in the sector rotation cycle in terms of early and late-cycle leaders (MP - TAE; p. 527) |
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Definition
| (1) Early cycle leaders and some others peak out (near the top, left shoulder); (2) Late-cycle leaders at new highs: bear market rally for other stocks (during the last market peak, head); (3) Bear market rally for most stocks: some late-cycle stocks reach bull market peaks (first false rally after peak, right shoulder); (4) Early-cycle leaders have either bottomed or are experiencing superior relative strength (market bottom) |
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Term
| Describe the three types of market peak (MP - TAE; p. 528) |
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Definition
| (1) Those that develop after a prolonged bull market, extending over several business cycles; (2) 'Recession-Associated Top' (RAT): profits in general are under attack as distortions within specific sectors spill over and create economic contraction; (3) Double cycle peaks: linked to the slowing down of the economy but not an actual contraction |
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Term
| What is the 'three step and tumble' rule? (MP - TAE; p. 477) |
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Definition
| (Edson Gould) After three consecutive rate hikes, the equity market is likely to stumble, that is, to enter a bear market. It is a recognition that a significant rise in interest rates and tightening of monetary policy have already taken place |
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Term
| What do high and low readings on the ADX indicator show? Can it be linked to a trend reversal? (MP - TAE; p. 250) |
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Definition
| High readings on the Average Directional Index (ADX) indicate that the price series is in a trending mode (i.e. lots of direction) and low readings indicate a trading range market (i.e. lack of direction). High readings in themselves do not tell us that market is overbought. However, when the ADX is at a high reading and starts to reverse, the prevailing trend is likely to change. Similarly, low readings in the ADX that begin to break-out suggest that a new trend may be developing |
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Term
| Explain the relatioship between momentum & moving averages with market tops (MP - TAE; p. 531) |
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Definition
| (1) Momentum typically leads price, especially at market tops. Occasionally, it is possible to identify multi-year tops or trendline violations in several long-term ROC indicators. Spotting trendline breaks in the 12-, 18- and 24-month ROCs often indicate that the cycles they reflect are beginning to turn; (2) If the DJIA and SPX have crossed below their (7- and) 12-month SMAs, there is a good chance that the bear market is underway |
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Term
| Explain the relationship between volume, moving averages, sector rotation and market bottoms. Also, explain how market bottoms compare with market tops (MP - TAE; p. 535) |
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Definition
| (1) Record volume coming off the lows is typically a strong confirming sign of a market bottom. Bottoms also often include a subsequent test of the low; (2) An important confirming signal is the ability of the SPX to rally above its 12-month SMA; (3) An improving trend of relative strength favoring early-cycle leaders typically confirm the bottoming out process is underway; (4) Market tops often last longer than market bottoms |
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Term
| Suggest factors for designing a successful trading system (MP - TAE; p. 541) |
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Definition
| (1) Back-tested over a sufficiently long period; (2) System must be defined precisely; (3) Setting aside enough capital to survive 'the worst losing streak'; (4) Using a portfolio diversified across several markets |
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Term
| Explain how readings of Market Vane polls are interpreted and suggest whether the following is significant: 'an extremely high bond bull reading in a bear market' (MP - TAE; p. 496) |
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Definition
| Market Vane polls a sample of market participants on a regular basis. It is a contrarian indicator in theory since if a significant number of traders are bullish/bearish on a particular market, they are already positioned as such and the market has little way to go further. It is typically used as a contratrend indicator, with the strongest signals showing cases where traders are positioned against the larger trend (e.g. an extremely high bond bull reading in a bear market). |
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Term
| Explain how margin derbt levels are used as a sentiment indicator (MP - TAE; p. 501) |
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Definition
| Margin debt tends to be relatively low at the beginning of a stock market cycle, beginning to rise shortly after the final bottom. MD tends to flatten or decline within 3 months of most primary stock market peaks. Hence, it serves as a lagging confirmation of bottoms (by rising) and tops (by flattening or declining shortly after peaks). Contracting margin debt is therefore bearish, indicating a lack of confidence |
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Term
| Suggest what 'flow of fund indicators' are typically used for and when they might not offer much use (KD - TA; p. 177) |
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Definition
| They are typically a good means of assessing the available funds for investment - the most reliable signs seem to come from interest rates. They appear to work poorly during emotional times, when stock market prices appear to divorce themselves from economic reality |
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Term
| Explain how +DI and -DI are calculated and how trends are determined using these indicators. Also, explain how DX and ADX are calculated (KD - TA; p. 289) |
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Definition
| +DI is the ratio of the sum of +DM over 14 days (+DM14) to the 14-day True Range (TR14). When the +DI are greater than the -DI, the trend is upward. Crossovers often signal a change in the trend's direction. DX is the ratio of the absolute difference between +DI and -DI over the sum of the two DI. ADX is a moving average of the DX |
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Term
| Other things being equal, what circumstances would result in the most reliable crossover signal using MAs? |
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Definition
| A crossover that develops when the average is relatively flat |
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Term
| Suggest two factors that increase the potential effectiveness of a break-out signal from a rectangle pattern. Also, suggest a method for anticipating the break-out direction (KD - TA; p. 310) |
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Definition
| (1) When volume increases on a b/o; (2) Odds of a retracement decrease when the b/o occurs on a gap. When the price doesn't reach one of the two zones at an advanced stage of the pattern, it is a warning sign of the eventual direction of the eventual b/o (with up to 90% accuracy) |
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Term
| Explain whether rectangles are generally continuation or reversal patterns, and whether this differs at different stages of a security's cycle. Comment on the frequency of false b/os (KD - TA; p. 310) |
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Definition
| Rectangles are often (2/3 times) continuation patterns, but can often act as reversal patterns at bottoms. Over 75% of early b/os are false with rectangle patterns, so patience is key |
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Term
| Explain what rising and falling wedges signify, the main characteristics for identifying a wedge and comment on the frequency of b/os in different directions for each type (KD - TA; p. 322) |
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Definition
| Rising wedges suggest that sellers are becoming a little more anxious that the bullish support line will break. Falling wedges suggest that buyers are becoming anxious that the bearish resistance line will break. (1) Wedges tend to occur after a climax (peak or trough), but can also occur as a continuation pattern; (2) At least 5 reversal points are required to be touched to qualify as a wedge; (3) Declining volume is another characteristic of a wedge during its formation; (4) Studies have shown that 92% of declining wedges break out upward, and most rising wedges (69%) break out downward |
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Term
| Draw a flag and a pennant pattern in an upward trend. Explain how the price objective is determined for each, and suggest key characteristics to look for during the formation (KD - TA; p. 329) |
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Definition
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Term
| Explain what the 'measured rule' is and what type of patterns it applies to (KD - TA; 331) |
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Definition
| The 'measured rule' is used to calculate the price target for a flag or pennant pattern. It takes the distance from the trend's initial b/o to the point at which the trend is reversed. This implies that the reversal takes place at the halfway point between when the b/o occurs and the ultimate end of the trend |
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Term
| You have identified a security that you think has an 18-day cycle. You divide the daily prices for the security by the 6-day moving average. What do you expect a plot of this calculation will show? What is this process called? (KD - TA; p. 261) |
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Definition
| The plot will oscillate above and below the zero line and the lows of the plot should correspond to the lows in the cycle. This process is called 'detrending' |
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Term
| What is a Centred Moving Average used for? Explain if we can use it as a signalling method (KD - TA; p. 463) |
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Definition
| Used to identify cycles, but not as a signalling method because it lags behind prices |
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Term
| According to Kaufmann, what are the factors that drive the long-term direction of prices? (PK - NTSM; p. 62) |
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Definition
| *G*I*SD*E (1) Government Policy; (2) International Trade; (3) Supply & Demand; (4) Expectations |
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Term
| Explain what a 'downward reversal day' is and in what situations it may potentially be significant (PF - NTSM; p. 88) |
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Definition
| Day in which there is a new high followed by a lower close. Would potentially be significant if it follows a clear trend with sharply increasing volatility, or if it occurs at the highest point of the past few weeks |
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Term
| Explain the statistical rationale for trend-following. Also suggest some important parameters for trend-following, stating the most important decision in the ultimate success of the trading system (PK - NTSM; p. 285 & 299) |
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Definition
| Prices are not normally distributed and have fat tails, therefore creating a distribution that makes trend trading profitable. Trend speed and acceptable level of risk are important parameters, with the selection of trend speed (calculation period) being the most important |
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Term
| Define the factors that determine the degree of data-mining bias (DA - EBTA; p. 288) |
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Definition
| (1) Number of rules back-tested: rules back tested en route to discover the highest performing rule (+ correlated with DM bias); (2) Number of observations used to compute the performance statistic (-); (3) Correlation among rule returns: degree to which performance histories of the tested rules are correlated (-); (4) Presence (and magnitude) of positive outliers: if there is a very large return on a particular day (+); (5) Variation of expected returns among rules: if all rules have similar merit in terms of predictive power (thus low variation), there will be a high degree DM (-) |
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Term
| Explain how data mining works and what is the main problem with this practise (DA - EBTA; p. 255) |
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Definition
| Many rules are tested using algorithms and the rule with the best observed performance is selected. There is no guarantee that the selected rule will have similar performance in the future, nor indeed will it be continue to be the best rule |
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Term
| Suggest some solutions for reducing the risks associated with data mining bias (DA - EBTA; p. 320) |
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Definition
| (1) Out-of-sample testing: excluding one or more subsets of the historical data from the data-mining sample, then using this period to test the best rule discovered in the mined data; (2) Data-mining correction factors: Deflates the observed performance of the rule that did the best; (3) Randomization of methods: Uses methods like bootstrapping and Monte Carlo to allow significance testing of several rules without having to hold data aside |
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