Cycle analysis, which measures the overall flow of the market and is less dependent on traditional definitions of the open, high, low and close, is an area that should work well with modern markets. One cycle-based strategy that this magazine first covered in 1996 was the adaptive channel breakout. This method set the channel lengths in a channel breakout system as a percentage of the dominant cycle. Using multipliers of the dominant cycles produced a much better optimization space than simply optimizing lengths.
The best-known method to extract cycle information from data in general is Fourier analysis, which does not work well on financial data because the method requires a long stationary period. Maximum Entropy Special Analysis, or MEM, is an auto-aggressive technique to fit data to a series of sine waves to extract spectra by minimizing the error. Another method, which was recently popularized by John Ehlers, is Hilbert transform. This method uses a filter with known phase shifts and lags to estimate a single dominant cycle.
Overall, the best method is MEM, although some newer methods have surfaced that demand further study. These will provide interesting subject material for future articles.
The concept of walk-forward testing is similar to using out-of-sample data to validate strategies developed on in-sample data. As such, fundamental changes in how markets trade over time can reduce its usefulness. In walk-forward testing, however, the review period is more evolutionary. For example, optimization may take place over the last 10 years and out-of-sample testing on the 11th year. At the end of the 11th year, the 10-year window is shifted forward and the process repeats.
Classic walk-forward analysis uses simple, traditional parameters such as net profit and drawdown to select input values. We can demonstrate this with a simple triple moving average crossover system that has been modified so that it can be used in electronic markets. The classic triple moving average crossover enters at the next day’s open, but this system enters on a limit price at the prior close, which solves the problem of the overnight open on ICE, for example, not being liquid. "System code" (below) details the rules of the strategy.
This code is available as text on the following page.
We will test this system on cotton, mini natural gas, the euro, copper, the 30-year Treasury and mini crude oil futures, and merge the pit and electronic market by using the pit data until the volume of electronic is greater. Our source is Pinnacle data.