Stocks & Commodities V. 2:2 (48-54): Computers in the Futures Industry by William T.

Taylor

Computers in the Futures Industry

by William T. Taylor

T he futures industry, like other investment-oriented industries, relies heavily on information. For years,
exchanges have used the computer for price recording and data gathering as well as for accounting.
Computer technology has brought price data to thousands of traders through various quotation services.
In fact, the computer can bring a trader so much data that there is virtually no way a human being could
possibly absorb the data and transform it into information in time to be useful.
Notice, I'm making a distinction between data and information here. Data are just prices, supply and
demand figures, production estimates, news items and so forth, that can affect the activity of the various
markets. information on the other hand, is produced by an orderly assimilation of the data, sorting out the
important from the irrelevant, and organizing it into some useful format.
The computer can help the trader accomplish the task of converting data into information, but not by
itself. Alone, the computer is nothing more than a machine, a piece of hardware. It is the programs or
software that instruct the computer how to perform its functions with great speed an accuracy,
transforming the barrage of data into usable information for the trader.
Until recently, the specialized software needed by the trader was not available for micro-computers. Only
traders with computer programming knowledge were able to use the power of computers, by developing
software for their own use. But gradually the market for software services began to grow, attracting the
talent necessary to develop programs and data services for the trader. As recently as five years ago, only a
handful of traders were using small microcomputers to assist them in trading. Now thousands of
individuals and firms all over the world are using this powerful tool.

Trading Systems
Trading systems have been around since long before the computer. Traders, believing that information
relating to a specific commodity was reflected in the current prices, could simplify their trading strategies
by developing price-tracking systems to generate buy and sell signals. This was all part of the
development of an approach to trading called technical analysis.
Trading systems come in many shapes, and have various functions. Some follow trends, such as the
Moving Average systems. Others, like the Oscillator, are designed to work well in congested markets.
Still others follow cyclical and seasonal fluctuations. Trading systems can be used to analyze a variety of
data, such as price, volume and open interest figures, to help the trader pick the proper time to buy or sell.
A system may tell a trader to hold a position for an extended period of time. Or, by constantly monitoring
the market during the course of the day, signaling when to get in or out of the market, a system can give
the trader the option of intra-day trading.
These trading systems give the trader a plan by which he can buy, sell, hold, or exit the market. While
this removes much of the emotion surrounding trading decisions, it also creates a lot of "homework" for
the trader: he or she must update charts, and make numerous calculations. The trader who uses complex
trading systems for several different commodities has very little time left over to do more research and

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development of better trading systems.

Another drawback is that, as in any manual operation, there always is an "error factor". Stress increases
the chance for error and, as we all know commodity trading is one of the most stressful occupations in
the world. By taking the routine, monotonous, error-prone manual operations and replacing them with
machine calculations the computer alleviates this problem. The trader has telephone access to large data
bases and can obtain the data necessary to drive trading systems. Using the signals generated by the
computer, the trader can make market decisions, give market orders to his or her broker, and be done for
the day.
A big advantage of the micro-computer is that it trades in the market, coolly and unemotionally. Gone are
the fears that the trader made a mistake in calculating a moving average or copied a price incorrectly, and
barring a hardware failure, the computer will not forget the trading rules. In addition, the data services are
very reliable, and a safeguard can be built into the computer program that checks for data out of certain
bounds.
There is, however one fear that mechanical trading systems, manual or computerized, have not alleviated.
That is the fear that the system is no longer effective. This fear, which increases as each consecutive loss
is incurred, leads to a second advantage the computer has for the commodity trader - that of research.
New systems, or variations on existing systems can be examined by computer. Historical data available
from any of the many data services allows the trader to "paper trade" his or her system without going
through a "smoke test" in the actual market. By trying the system under a variety of market situations, the
trader can "optimize" its performance and adjust system parameters accordingly.

Computerized Optimization Of Trading Systems

With the widespread use of computer-based trading systems, traders, analysts, brokerage houses and
portfolio managers are becoming increasingly concerned about optimizing system performance.
Optimization is accomplished by having the computer "try" a large number of different combinations of
parameters or "rules", and then having the computer decide which parameter combination worked "best".
An example of a trading system parameter is the length of a moving average used. A thorough
examination of a trading system must involve the testing of thousands of parameter combinations to find
the best.

Static and Dynamic Analysis

To date, there have been two main approaches to computerized optimization. The first, called Static
Analysis, assumes that in a given trading system there is an optimum parameter combination used to
trade a given commodity. This parameter combination is thus expected to work well in the future. The
Static Analysis approach looks at a relatively long time series of data to determine optimum parameters
— at least three years.
The second approach, called Dynamic Analysis, assumes that the character of the market changes so that
the optimum parameter combination may shift over time. Thus, systems must be "reoptimized" from time
to time, to keep up with the changing nature of the market. The time period over which a system is
optimized would vary from commodity to commodity but generally it would be less than one year. As a
byproduct of Dynamic Analysis the trader often identifies parameter combinations that persist in
producing profits, even though they are not necessarily the optimum.

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One other consideration: In order to find the "best" performance of a system, one must-define "best". Is
the trader looking for highest net profit, highest probability of a profitable trade, or lowest risk to ratio?

Defining Criteria For Evaluating Trading Systems

Because there are many "best" results possible from any given trading system, one should look at several
criteria that can be used to determine optimum performance. Each has its advantages and disadvantages.
The discussion of criteria selection begins with five core criteria, and develops a total of eighteen
evaluative concepts. The five core criteria are as follows:
• Total Net Profit
• Average Net Profit
• Coefficient of Variation of Average Net Profit
• Risk to Return Ratio
• Probability of a Profitable Trade
Each criterion will be discussed in turn with the desirable and undesirable characteristics highlighted.

Total Net Profit

This criterion represents total profit minus total losses and transaction costs (commissions). The value
may be positive, negative, or zero. Obviously a high positive value for Total Net Profits is the trader's
ultimate goal.
Because Total Net Profit shows only the "end" result of trading a particular system, it doesn't delineate
the path taken to attain that net profit. It does not show the losses, drawdowns, and margin calls
experienced in the course of trading. Generally, a parameter combination that yields lower net profit but
less loss, and correspondingly fewer margin calls, is preferred over one yielding high net profit but larger
losses and more margin calls. The Total Net Profit criterion by itself has no direct relationship to the real
rate of return for the particular trading system.
There is another obvious problem when using the Total Net Profit criterion in a situation where a given
system's performance is compared over time periods of different lengths: more trades can occur over a
longer period of time and thus higher net profits are possible.

Average Net Profit

To compensate for some of the problems associated with the Total Net Profit criterion, The Average Net
Profit often is used as a criterion. The Average Net Profit also can take on a positive, negative or zero
value and, again, a high positive value is most desirable.
A high Average Net Profit is the result of two separate factors at work. They are one, high total net profit,
and two, a small number of trades. This criterion, sometimes referred to as the "Expected Value of a
Trade", is well suited to comparing performance over time periods of differing lengths. However,
optimizing a trading system based on the highest average net profit does not insure that the total net profit
will also be optimized, and that, after all, is what the trader is shooting for. A high average net profit can
be generated by a few good trades. High total net profit is generated by many good trades.

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A second weakness in this criterion is that an "outlying" value that is well above or below the majority of
the observed data can unduly "pull" the average up or down. If there is a sufficiently large number of
"outliers", the observed values become so dispersed that the usefulness of this criterion as a predictor of
the expected value is diminished.
In any analysis of average or "mean" value, the Standard Deviation of the mean must be considered.
The standard deviation is a statistical measure of dispersion around the mean value or in this case a
measure of how close actual profit on a trade is to the average value. A high standard deviation indicates
there is a wide variation in observed values, and a low standard deviation indicates the observed values
tend to cluster around the mean value. In what statisticians call the normal distribution or Bell-Shaped
curve, approximately sixty-eight percent of the observed values fall within one standard deviation of the
mean. About ninety-five percent of the observed observations fall within two standard deviations of the
mean.
Standard deviation, or variance (standard deviation squared) are often used as a measure of risk. When
the standard deviation is high, the mean is not a reliable predictor of average net profit for an individual
trade. When the standard deviation is low, the mean becomes more reliable as a predictor of the expected
value of a trade.
It is not really practical to use the standard deviation itself as a criterion. A low mean value can have a
high or low standard deviation, and a high mean value can also have a high or low standard deviation.
Ideally, the value of the standard deviation relative to its mean should be examined.

The Coefficient of Variation Of Average Net Profit

To account for the limitation of the Average Net Profit criterion mentioned above, the Coefficient of
Variation is used as a criterion. Interpreted as a measure of risk relative to the average return, it is
calculated by dividing the Standard Deviation of the mean by the mean value itself, and multiplying the
resulting quotient by 100. The result is a unitless, relative measure by which comparisons can be made.
The smaller the coefficient of variation, the lower the standard deviation is relative to the mean. Strictly
speaking, the desirable value for the coefficient of variation should approach zero rather than be
minimized. The coefficient of variation can take on negative value as a result of negative average net
profit, which presumably, one would like to avoid. For our purposes a low positive value is the most
desirable.

A Risk to Return Ration

Another measure of risk relative to return is calculated by dividing the average value of unprofitable
trades by the average value of profitable trades. This criterion is interpreted as the dollar risk relative to
the dollar gain. A risk-to-return ratio of –0.5000 reflects a $50.00 risk (loss, outlay) for the gain of
$100.00. Values close to zero are the most desirable since they represent the least loss relative to gain.

Probability of a Profitable Trade

This criterion, as the name indicates, represents the probability that a given trade will make money for the
trader. It is calculated by dividing the number of profitable trades by the total number of trades. It is
sometimes called the "percentage of profitable trades." Values approaching 1.00 are the most desirable.
The disadvantage of this criterion is that it tells us nothing about the magnitude of the profitable trades.
(In other words, how much money was made!)

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Optimizing Short or Long Trades

Hedgers who use a mechanical trading system to strategically place their hedges only when the trading
system provides a short (or long, depending on the type of hedge) signal, find it possible to use the
computer to optimize a system for the short (or long) trades only. One does not have to compromise
performance of trades by using a system designed to play both sides of the market.
By using the five core criteria previously mentioned to evaluate only short or only long trades, the total
number of criteria is increased to fifteen. The ten new resultant criteria are as follows:
• Total Net Profit on a Short Trade
• Average Net Profit on a Short Trade
• Coefficient of Variation of Average Net Profit on a Short Trade
• Risk to Return Ratio of a Short Trade
• Probability of a Profitable Short Trade
• Total Net Profit on a Long Trade
• Average Net Profit on a Long Trade
• Coefficient of Variation of Average Net Profit on a Long Trade
• Risk to Return Ratio of a Long Trade
• Probability of a Profitable Long Trade

The Composite Criteria

It's clear that each criterion used to evaluate the performance of a trading system has at least one
drawback that keeps it from being the sole criterion with which to evaluate a trading system. Instead, a
composite criterion is created by combining all of the "core" criteria. Thus each parameter is evaluated
by each criterion in turn and given a ranking of second best, and so on. The numbers are then summed for
each parameter combination to arrive at a composite "score". The lower the score, the better the
parameter combination is, based on a variety of performance criteria rather than just one criterion.
When using this process, each criterion rank is weighted equally in determining "overall best"
performance. However, the trader may choose to weight each criterion's rank, to emphasize some criteria
and deemphasize others. Such weighting requires a subjective judgment on the part of the trader, based
on his experience, psychological makeup and wisdom.

Evaluating Criteria—Some Techniques

Each criterion should be analyzed with regard to evaluative variables, such as the number of trades, and
number of profitable trades. Even the other criteria should be considered. For example, a system
optimized on Total Net Profit might also display the data for Average Net Profit to see if it too was
optimum, or nearly so. Figure 1 shows an example of such an evaluation printout depicting the results of
a Dual Moving Average System with penetration. There are about fifty such evaluative variables used in

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this particular approach.

The Mapping System of Test Strategy

A useful technique for analyzing a large number of parameter combinations is the Mapping System of
Test Strategy. This process is similar to one developed by Perry J. Kaufman in his book Technical
Analysis in Commodities. As the name indicates the system involves using a graph, which is basically a
map (shown in Figure 2). The coordinates are values of the length on the parameters to be analyzed — in
this case the lengths of long-run and short-run moving averages. The numbers on the y-axis (vertical),
labeled LONG, represent the number of days used in the calculation of the long-run moving average. The
numbers along the x-axis (horizontal), labeled SHORT, represent the number of days used in the
calculation on the short run moving average. The symbols and numbers at the bottom of the map
comprise the legend. The darker the shading, the higher the value for the criterion evaluated. In this case
it is Total Net Profit.
While ideally suited for two parameter systems, the Mapping System of Test Strategy quickly reaches a
limit of usefulness if a third parameter is introduced, particularly if that parameter can take on a large
number of values. For each value of the third parameter, a new map is generated. In order to make
comparisons, then, all of the maps must be examined side-by-side. Obviously, if there are a lot of maps to
look at, it will be difficult to find the optimum parameter combination. Thus, the third parameter should
be chosen so that it will take on ten or fewer values.

Parameter Characteristics
Frequency charts of parameter values from the most effective systems can tell a lot about a system. For
example a system may show the predominance of a certain parameter value. Figure 3 shows such a
frequency chart for the moving average system examined in Figure 2. The parameter under consideration
in this case is LONG, the number of days used to calculate the long-run moving average as it appeared in
the top twenty-five parameter combinations optimized for Total Net Profit. Notice that the long-run
moving average that appears most often is twelve days. By checking the other parameter value frequency
charts, the trader can identify a group of parameter combinations that for all practical purposes are
optimum.

Routine Statistics
For each criterion evaluated, the routine statistics of the top parameter combinations should be examined
also. This is particularly useful to identify the ranges into which the values for parameters,
evaluative variables and criteria fall. The statistics shown in Figure 4 represent the mean, standard
deviation, and minimum and maximum values for the top twenty-five parameter combinations.

Capital Management
To determine the capital investment required for trading with a particular system, the strings of
consecutive gains and losses should be analyzed. This tells the trader not only the longest string of
consecutive losses (gains), but also how long each string of consecutive losses (gains) lasted. The dollar
value of these strings of losses and gains should be examined as well. A parameter combination of a
particular trading system may experience a long string of losses but actually lose very little money,
compared to a short string of losses involving large sums of money. The trader will need to know that.

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Figure 5 shows for each parameter combination of a moving average system, the maximum and
minimum gain, as well as maximum and minimum loss for each string of consecutive profitable and
unprofitable trades. Parameter combinations that show up among the top performers of a given trading
system can then be examined in light of the capital requirements necessary to trade with that system.
Another method of examining the capital requirements of a particular trading system's performance is to
look at a graph of cumulative profits over the trading period under consideration. The trader can see at
a glance the pattern of gains and losses. An example of such a graph is shown in Figure 6.

Summary and Conclusions

The computer today is an integral part of futures trading. It handles the processing needs of exchanges,
brokerage houses and individuals by supplying the data necessary to conduct business. The computer
provides the trader with a powerful tool with which he or she can sift through a virtual mountain of data
and extract the necessary information.
With a growing number of traders using micro-computers, trading software is becoming more and more
available to the user. These programs assist the trader by eliminating the manual, error-prone operations
of calculations and data maintenance, freeing the trader to use the computer for research on trading
systems. Because of its speed and its capacity to store data for alter recall, the computer is ideal for
testing different trading strategies and rules. By comparing the results of these simulations, the trader can
optimize the performance of a particular system.
The optimum performance can be measured on a variety of criteria. They include, but are not limited to,
Total Net Profit, Average Net Profit and Risk to Return measurements. Each criterion has its advantages
and disadvantages. One can trade with a system optimized on a particular criterion if, in the opinion and
experience of the trader, that criterion's limitation is not serious. Another approach to system
optimization is to develop a composite criterion which incorporates the information obtained from
several criteria.
In addition to the optimization of a trading system based on whatever criterion or set of criteria the trader
feels is appropriate, the characteristics of the top parameter combinations should be examined. This tells
the trader whether certain ranges of parameter values cluster around the same value indicating that
parameter values within a certain range will essentially perform in a similar manner.
Capital requirements analysis is another area of trading system performance that cannot be ignored. The
trader should know how much additional margin money may be required to follow a particular system
and to calculate the rate of return on investment. This can be accomplished in at least two ways. First by
looking at the strings of consecutive gains and losses and second, by examining the cumulative profit
graphs.
The human factor of commodity trading is necessarily great, owing to the fact that there are large
numbers of market participants with varied backgrounds, purposes and goals. Trading systems, though
they may be run on computers and optimized on computers, are still constructs of the human mind. While
the computer may dispel the trader's fear of making a calculation error, or incorrectly copying the data
going into a trading system, it may not dispel the fear that the trading system itself is no longer effective,
particularly if the trader has experienced several consecutive losing trades. The capacity of the computer
to assist in the research and optimization of trading systems, by simulating realistically complex trading
situations on which to test them, addresses this fear by letting the trader know that he or she has done

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Figure 6
Cumulative Profit Plot
Moving Average System
Long=41 Short=2 Penetration=0.002

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everything possible to insure that the system is effective.

Author's Background
Mr. Taylor's expertise is in the areas of data processing and computer programming especially as
applies to commodity trading. His firm, Computerized Commodity Research, was started in 1979 for the
purpose of providing custom research services and software development for testing trading and hedging
strategies where "off the shelf" software was not available. In addition, Mr. Taylor provides special
research reports on selected topics and provides computer training for commodity professionals. He is
writing the book Microcomputers and Commodity Trading: A Practical Handbook, scheduled to be
published this Spring, and co-authored Gold Trading - An Analysis of Major Trading Systems with
Robert H. Meier and others. Mr. Taylor holds both bachelors and Masters degrees in Economics.

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