INTERMARKET TRADING STRATEGIES

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1 INTERMARKET TRADING STRATEGIES Markos Katsanos A John Wiley and Sons, Ltd., Publication

3 Intermarket Trading Strategies

4 For other titles in the Wiley Trading Series please see

5 INTERMARKET TRADING STRATEGIES Markos Katsanos A John Wiley and Sons, Ltd., Publication

6 Copyright C 2008 Markos Katsanos Published by John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, Saffron House, 6 10 Kirby Street, London, ECIN 8TS, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or ed to permreq@wiley.co.uk, or faxed to (+44) Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The Publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the Publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Other Wiley Editorial Offices John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA , USA Wiley-VCH Verlag GmbH, Boschstr. 12, D Weinheim, Germany John Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore John Wiley & Sons Canada Ltd, 6045 Freemont Blvd, Mississauga, ONT, L5R 4J3, Canada Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data Katsanos, Markos. Intermarket trading strategies / Markos Katsanos. p. cm. Includes bibliographical references and index. ISBN Investment analysis. 2. Portfolio management. I. Title. HG4529.K dc British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN (HB) Typeset in 10/12pt Times by Aptara Inc., New Delhi, India Printed and bound in Great Britain by TJ International Ltd, Padstow, Cornwall, UK

7 To my wife Erifili

9 Contents Acknowledgments Introduction ix xi PART I 1 1 Intermarket Analysis 3 2 Correlation 17 3 Regression 33 4 International Indices and Commodities 41 5 The S&P European Indices 85 7 Gold 93 8 Intraday Correlations Intermarket Indicators 121 PART II Trading System Design A Comparison of Fourteen Technical Systems for Trading Gold 175

10 viii Contents 12 Trading the S&P 500 ETF and the e-mini Trading DAX Futures A Comparison of a Neural Network and a Conventional System for Trading FTSE Futures The Use of Intermarket Systems in Trading Stocks A Relative Strength Asset Allocation Trading System Forex Trading Using Intermarket Analysis Conclusion 293 Appendix A MetaStock Code and Test Specifications 297 Appendix B Neural Network Systems 357 Appendix C Rectangles 367 Glossary 371 Bibliography 385 Index 391

11 Acknowledgments I am particularly indebted to Dr Evangelos Falaris, Professor of Economics at the University of Delaware, who took the time to review selected chapters and offered both technical and expositional comments. Many thanks also to Murray Ruggiero, one of the world s leading experts in intermarket analysis, who contributed to improving the final version of the book by making valuable comments and suggestions on a preliminary manuscript. Murray is Vice President of Research and Development of TradersStudio, contributing editor for Futures Magazine and author of several books on trading systems. Special thanks to my wife, Erifili, for her love and patient support, and for putting up with late nights, despite having no actual interest in the subject. I also want to thank Jayanthi Gopalakrishnan, the editor of Technical Analysis of Stocks & Commodities magazine, for encouraging me to write the articles for the magazine and helping me later with the task of finding the best publisher for the book. Many thanks also to Caitlin Cornish, my editor at John Wiley & Sons, and to her assistant Aimée Dibbens, for their guidance and support during the publication process. It is difficult to appreciate the effort and hours that go into researching and writing a book of this nature until you ve had a chance to work on one yourself. The correlation studies involved a huge amount of historical data and I would like to thank Peter Day for helping out with the VBA to manage the data in Excel and Rubi Cabal, marketing director at CSI data, for allowing me access to CSI s correlation reports. Finally, I would like to thank the technical support staff at Ward Systems Inc., and also Lynn Dufrenne, Lead Support Representative at Equis Technical Support for their help in solving the unavoidable software problems.

13 Introduction With the emergence of the internet and international cross border trading, the world s futures and equity markets started to converge, making intermarket analysis an essential constituent of technical analysis. Single market technical analysis indicators were designed in the 1980s for national markets, and are no longer sufficient nor can be relied upon for analyzing the constantly changing market dynamics. But how do markets interact and influence each other and how can we use intermarket relationships to construct a viable technical system? Because the answers have been so elusive, they became the motivation for my research. The more I looked into it, the more I became convinced that there is clear and incontrovertible evidence that the markets are linked to each other, and incorporating intermarket correlations into a trading discipline can give a trading advantage. Two years of research later, I finally came up with some rules and mathematical formulae for intermarket trading. It has been more than 15 years since John Murphy, a pioneer on the subject, wrote his first book on intermarket analysis. The material in my book is based on original research not published anywhere else and, unlike Murphy s intuitive chart-based approach, I am going to use mathematical and statistical principles to develop and design intermarket trading systems appropriate for long- and short-term and even day trading. Although the book makes extensive use of market statistics obtained from hundreds of correlation studies, the data and empirical findings are not its heart. They serve as a background in developing the trading systems presented in the second part of the book, as well as help shape our thinking about the way the financial markets work. The key difference between Intermarket Trading Strategies and other books on trading lies in its philosophy. I believe that knowing how the markets work is, in the end, more important than relying on a black box mechanical system that produced profitable trades in the past but not even the creator of the system can fully explain

14 xii Introduction why. The focus of this book is how intermarket analysis can be used to forecast future equity and index price movements by introducing custom indicators and intermarketbased systems. A total of 29 conventional and five neural network trading systems are provided to trade gold, the S&P ETF (SPY), S&P e-mini futures, DAX and FTSE futures, gold and oil stocks, commodities, sector and international ETF, and finally the yen and the euro. Naturally, past results are no guarantee of future performance. Even so, the results of out-of-sample back-testing are compelling enough to merit attention. Some results are more compelling. The multiple regression gold system, presented in Chapter 11, returned an amazing $1.2 million of profits on a $ initial equity. The stock index trading systems also produced impressive profits. The profitability of the Standard & Poor s e-mini intraday system was neither standard nor poor, producing a 300 % profit during the test duration. Investors who prefer to trade only stocks will find intermarket systems for trading oil and gold stocks in Chapter 15. My favorite is the oil stock system which made more than $1.6 million on an initial equity of only $ The foreign exchange (or Forex) market, which until recently was dominated by large international banks, is gaining popularity among active traders, because of its superior liquidity and 24-hour trading. Readers who are interested in forex trading will find, in Chapter 17, an intermarket system for trading the yen which made over $ on an initial $3000 account. The EUR/USD is the most popular currency pair among forex traders and the chapter on forex wouldn t be complete without a system for trading the euro. The next section in Chapter 17 presents two systems: a conventional and a hybrid system. The latter is an excellent example of how you can enhance a classic system by adding intermarket conditions. The hybrid system improved considerably on the profitability of the traditional trend-following system, almost doubling the profit factor while reducing drawdown. The system design is fully described from the initial concept to optimization and actual implementation. All systems are back-tested using out-of-sample data and the performance statistics are provided for each one. The MetaStock code for all systems is provided in Appendix A and a detailed procedure for recreating the artificial neural network systems in NeuroShell Trader is included in Appendix B. The benefits of diversification, and an example of static portfolio diversification by optimizing the portfolio allocation based on the desired risk and return characteristics, are discussed in the first chapter and a dynamic portfolio allocation method, based on market timing and relative strength, is included in Chapter 16. The book is divided into two parts. Part I serves as a background to Part II and includes an overview of the basics of intermarket analysis, correlation analysis in Chapter 2 and custom intermarket indicators in Chapter 9. Part II uses many of the concepts presented in Part I to develop custom trading systems to trade popular markets like US and European stock index futures, forex and commodities.

15 Introduction xiii The chapters in this book are divided as follows. The book begins with a discussion of the basic principles of intermarket analysis and the benefits of portfolio diversification by including uncorrelated assets such as commodities and foreign currencies. Chapter 2 explains the concept of correlation and the basic assumptions used. Chapter 3 explains the linear regression method used for predicting one security based on its correlation with related markets. An example using the S&P, the VIX and the Euro Stoxx is also included. Nonparametric regression (involving nonlinear relationships) is also briefly discussed. Chapter 4 is an overview of major international financial, commodity and equity indices including the DAX, the CAC 40, the FTSE, the Euro Stoxx 50, the Nikkei 225, the Hang Seng, the dollar index, the oil index, the CRB index, the Goldman Sachs Commodity Index, the XAU, the HUI, and the Volatility Index (VIX). Chapter 5 examines the correlation between the S&P 500 and major US and international equity, commodity and other indices. Chapter 6 examines long-term, short-term and even intraday correlations between major European indices and stock index futures and explains how they can be applied to develop trading systems. Chapter 7 is about gold and its correlation with other commodities, indices and foreign exchange rates with special emphasis on leading/lagging analysis. In Chapter 8 of this book I examine intraday correlations, especially useful for short-term traders. A leading/lagging correlation analysis between the S&P e-mini, the Dow e-mini, DAX and Euro Stoxx futures is also included. Chapter 9 presents various custom intermarket indicators and explains how each one can be used within the framework of a trading system. These include eight new custom intermarket indicators, published for the first time in this book. The MetaStock code for all indicators is included in Appendix A. The personal computer has revolutionized the creation and testing of trading systems. The inexpensive software takes out much of the work needed for testing, allowing the trader to test endless permutations of rules and parameters. In Chapter 10, I present some techniques for developing a trading system and evaluating the test results. I suggest methods of avoiding curve fitting and the illusion of excellence created by optimization. I also discuss stop-loss and other money management techniques. Finally, a brief introduction to neural network systems will explain the basic principles of this alternative approach for designing trading systems. Chapter 11 compares the performance of 15 intermarket systems for trading gold based on the intermarket indicators in Chapter 9 and using gold s correlations with the dollar index, the XAU and silver. Chapter 12 describes a long-term market timing system for trading the S&P ETF (SPY) using a market breadth indicator, and for traders who prefer the emotionally charged world of short-term trading, a hybrid system for trading the S&P e-mini using 5-minute intraday correlation with Euro Stoxx 50 futures.

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