Automating the Precision Trading System An Interactive Qualifying Project submitted to the Faculty of WORCESTER POLYTECHNIC INSTITUTE in partial fulfillment of the requirements for the Degree of Bachelor of Science By Mihnea Andrei Yar Zar Moe Htet Myo Han Latt With help from: Michael Radzicki Hossein Hakim Date: 5/26/13 Report submitted to: Professor Michael Radzicki Worcester Polytechnic Institute This report represents work of WPI undergraduate students submitted to the faculty as evidence of a degree requirement. WPI routinely publishes these reports on its web site without editorial or peer review. For more information about the projects program at WPI, see http://www.wpi.edu/Academics/Projects. ABSTRACT The purpose of this project is to scientifically create an automated trading system that would perform well in different market conditions and that would offer investors the confidence of trading it. The team used a $400,000 simulated account on the TradeStation platform to develop and optimize the strategy. 2 Table of Contents ABSTRACT .................................................................................................................................... 2 Table of Contents ............................................................................................................................ 3 Table of Figures .............................................................................................................................. 8 Table of Tables ............................................................................................................................... 9 CHAPTER 1: SYSTEM OBJECTIVES ....................................................................................... 10 High Winning Percentage ......................................................................................................... 10 High Annual Return .................................................................................................................. 11 Low Draw-Down....................................................................................................................... 12 Robust Across Different Markets .............................................................................................. 12 Low Time Commitment for Trading ......................................................................................... 13 Spends a Big Amount of Time in the Market ........................................................................... 13 Holding Trades over Night ........................................................................................................ 13 CHAPTER 2: FINANCIAL INSTRUMENT TRADED (STOCKS) ........................................... 14 Personal Interest ........................................................................................................................ 14 Liquidity .................................................................................................................................... 15 Tax Implications and Margin Rules set by FINRA................................................................... 16 CHAPTER 3: LITERATURE REVIEW ...................................................................................... 18 Asset Classes: Bonds .................................................................................................................... 18 Options................................................................................................................................... 19 Stocks..................................................................................................................................... 20 Major Stock Exchanges ............................................................................................................. 22 Trading Platforms ...................................................................................................................... 22 TradeStation........................................................................................................................... 23 MetaTrader 5 ......................................................................................................................... 25 Different Types of Trading and Active Investing Systems ....................................................... 26 3 Efficient Market Hypothesis (EMH) ..................................................................................... 26 Dow Theory ........................................................................................................................... 27 CAN SLIM ............................................................................................................................ 29 Capital Asset Pricing Model (CAPM) ................................................................................... 31 Manual Trading vs. Automated Trading ................................................................................... 33 Fundamental Analysis in Stock Trading ................................................................................... 34 Profitability ............................................................................................................................ 35 Management Effectiveness .................................................................................................... 35 Income Statement .................................................................................................................. 36 Balance Sheet ........................................................................................................................ 36 Cash Flow Statement ............................................................................................................. 37 GDP ....................................................................................................................................... 37 Unemployment ...................................................................................................................... 38 Interest Rate ........................................................................................................................... 41 Inflation ................................................................................................................................. 44 Technical Analysis in Stock Trading ........................................................................................ 45 Strategies ................................................................................................................................... 46 Trend Following Strategies ................................................................................................... 46 Support & Resistance Strategies............................................................................................ 47 Volatility Expansion Strategy ................................................................................................ 47 Basic Tools ................................................................................................................................ 48 Trend Lines ............................................................................................................................ 48 Channels ................................................................................................................................ 50 Japanese Candlesticks ............................................................................................................ 52 Fibonacci ............................................................................................................................... 53 Commodity Channel Index (CCI) ......................................................................................... 53 Relative Strength Index (RSI) ............................................................................................... 54 Moving Averages (MA): Simple Moving Average (SMA)&Exponential Moving Average (EMA) .................................................................................................................................... 55 Random Walk Index (RWI) .................................................................................................. 56 Average True Range (ATR) .................................................................................................. 57 4 Pivot Points ............................................................................................................................ 58 Bollinger Bands ..................................................................................................................... 59 Average Directional Index (ADX) ........................................................................................ 60 Volume .................................................................................................................................. 60 Order Types ............................................................................................................................... 61 Market Orders ........................................................................................................................ 61 Limit Orders .......................................................................................................................... 61 Stop Orders ............................................................................................................................ 62 CHAPTER 4: THE SYSTEM