## Wednesday, October 20, 2010

### Methodology

I should probably explain exactly what I'm doing in my forecast so people understand. As some have commented, there are many ways to do it, and I just chose one. I will probably continue to tweak this methodology until we can get some good forecasts, not ones that look so random.

First things first, why am I even doing this kind of forecast? Far too many trading systems are backward looking. I am trying to find something that looks ahead and can tell me more about the future. I have other trading signals I also use, but it would be good if I had a reference that could help me know when to hedge my core positions, whether they are long or short. Supposed I'm short the market, and I get a consensus forecast that points to a bounce -- it would make sense to buy some protection against my short positions (maybe index call options or similar).

Here is a step by step of my approach:

1) I have gathered all Dow history going back to 1927 or so. I got this data directly from Dow Jones. DO NOT trust Yahoo for financial data. Their data is not correct. I want to look at the Dow because it has a far richer history of data, going back through many recessions and cycles.

2) I calculate all daily returns, plus the high and low returns for each day.

3) I enter a date that I want to forecast, so for today 10/20/2010

4) The program goes through all the data and finds the closest match to the daily returns of a 2-5 period look back. Here's an example of a two period study:

10/19/2010 posted a return of -1.48%
10/20/2010 posted a return of +1.18%

Find the closest match to a two day cluster in history:

3/24/2009 -1.49%
3/25/2009+1.17%

You can see that these two periods are nearly identical. So what happened next? That's what I'm plotting on the charts.

3/26/2009 +2.25%
3/27/2009 -1.87%

Now, there are many ways to do this. I could take the top 30 closest matches and average them. I could take more period samples, say, 2-20, and average the best historical matches. As for what is correct or incorrect, I have yet to really figure that out, so I can try out other methods until I find something that's reliable. I will say that a 6 period look back in my studies was correct about next day direction 60% of the time, and 76% of the time the market moved over 0.25% beyond what direction it predicted (so if it was positive, the market advanced at least 0.25% the next day at some point). Ironically, I'm not showing the 6 period look back. I will take a look at alternatives and do more testing.

I have done something similar. But I found it help to abstract a bit from one day returns. I also look at returns over n period spans for periods of length m. You seem to have fixed n=1. Also, derivative data have also been helpful. Variance and other proxies of volatility help filter false positives.

2. Correction to the above, I meant m=1 (day). IOW, Overlapping periods can be used to distinguish signal v. noise. (for example, what is the 5 day return vs. the daily return for the last 5 days).

Also, I admire your CPCE chart. Can you clarify what you mean by divergence? I am assuming CPCE vs. SPX Price. I am right?

3. Dan -- wow, your method is more complex than mine. I'm not sure how to duplicate what you're doing, but how well do your forecasts work, in your experience? The forecasts I'm producing are a bit random but do seem to provide a decent general direction. I wouldn't necessarily bet big on them.

By divergence on CPCE, I mean, the 5 day EMA must make a higher low as the market is making a higher high or equivalent high. For example, if today closed at new highs on the S&P but CPCE 5 day EMA is making a higher low than what was made a few days ago, then that's a divergence, and it's bearish.

4. Dan, I posted an example of a divergence on my CPCE trading link

5. Cool, Thanks, I will check it out.

Funny thing is that I had started my software about a week before you posted about your's on Daneric's site. I am also tweaking my analysis.

When I was only looking at one day returns, it was a bit more erratic. However, EW is basically a fractal lens to the market, and I was trying to Quantify it. So by looking over different time lengths AND spans we can gather sufficient context to discern, for example, bull runs from counter trend rallys. But as you are, I am skeptical of the power and prudence of this. One thing, for example, I want to see is if we would have had any warnings with the data through 10/87 about Black Monday.

Not home right now, but when I finish traveling I'll post any relevant insights I have in the comments section of your most recent post.