BUILDING A SYSTEM

John Jonelis
Presented to the Chicago Area MetaStock Group May and June 2006
Copyright 2006 John Jonelis, Revised 6/14/06

SUMMARY
These notes describe two workshops on building systematic trading models. Subjects covered are as follows:
Comments
Backtesting 101
Building an indicator
Building, testing, optimizing and proving a system
Testing across multiple markets
Backtesting 201
Testing with limit orders
Accounting for the overnight gap
Backtesting 301
Extending MetaStock by use of Excel
Handling optimized variables and documenting research
Applying comparative statistics
Applying a Monte Carlo simulation
Websites, Acknowledgements, Disclaimer
COMMENTS
I was given a heavy dose of Efficient Market Theory while at Northwestern in the 80s getting a Masters somewhat
late in life. The concept of efficient markets didnt ring true to me then, and I dont believe in it now. However, a
lingering respect remains for the complexity of finance, the time value of money, the intuitive use of statistics as a
blunt instrument, and the power of collaborative effort. Ive left fifty behind and at last count havewith the help
of unselfish collaboratorswritten hundreds of indicators and trading systems. To date, there are only a few that I
actually trade. It seems that it is not easy to find and exploit market inefficiencies on a consistent basis. But permit
me the opinion that what appears as noise to an investor may be signal to a trader.
It would be presumptuous and absurd to put forward a best method to such a complex subject as system
development. Thinking people disagree, and many have found success by other means. The following topics are
based on my personal philosophy. It is a structured approach, and goes as follows:
Test Using Broad Averages
It is difficult to find truth in the midst of turbulence. A close comparison of a number of individual trading
instruments will reveal that each has its own unique signature, one wildly different than the next. Price action is
subject to unexpected and drastic moves brought on by obscure information, unique to each particular security.
In contrast to an individual instrument, an index is more stable and predictable, because it represents an aggregate of
many parts. Test using the averages. Find out something about the market and work from that point. Test
combinations of indices that have disparate characteristicsparticularly ones of differing persistence and volatility.
Select among the models that work beston averageacross a set of such markets.
Test Across Large Sets of Data
Test against as much data as possible. The more data in the test, the more market conditions encountered. If the
strategy is multi-day, gather data from several markets and test across decades of it. Select between the methods
that work in most every applicable situation. Markets change, but prices still rise and fall. Past infers future
because tomorrows data likely bears some resemblance to data in the past.
Along these lines, our research group has created artificial data that mimics the characteristics of individual
marketscomplete with volume. The data exhibits fat tails, as do distributions of real markets. The idea is to test
across 1000 years of Dow, 1000 years of Nasdaq, and so on. Our data is not yet commercially available, but I
recently came across a book that may help those interested in doing something similar: THE (MIS) BEHAVIOR
OF THE MARKETS by Benoit Mandelbrot (ISBN 0-465-04355-0). Hes the inventor of fractal geometry.

BUILDING A SYSTEM - JONELIS - 2

Please notethe typical stylized variety of random data is of limited use. By definition, it conforms to the standard
distribution, and therefore cannot adequately describe the risks of real markets. I urge you to go beyond the
common academic approach.
A note on testing the equity index futures: Start by testing against index or cash market data. This may seem
counterintuitive, but it helps avoid a peculiar problem. Continuous futures contracts plot false price swings due to
the premium at contract expiration and rollover. This calls into question the validity of a test. Another advantage
significantly more index data is available than futures data, and quantity is the name of the game. Of course, it is
also true that any given futures contract is likely more volatile than the related index. But test on the index first,
then verify the completed model against the futures.
If the strategy is sufficiently short term, dont use continuous contracts at all. Test against individual contracts.
Because of its ability to simultaneously test multiple markets, MetaStock is capable of testing Futures on a contractby-contract basis.

Take Advantage of the Law of Large Numbers

The markets provide the opportunity, within certain constraints, to set up and run your own gameand people will
actually belly up to your table. You can open the table at your discretion and close the game when you choose.
Your table is a computer programyour game, a set of tested strategies. Your rules are the system components, as
well as the money management and execution practices you have determined to use. Create your own game and
play by your own rules. Be consistent and honor your rules.
Insurance companies, brokers, banks, and casinos each play their own game, and honor their rules. They make their
profits from the average expected return over a large number of events. A trader can do the same. Once a real
market advantage is identified, repeat the trade as many times as possible. If the model is valid, then the more
reps achieved, the closer the system can be expected to perform as tested.
How many trades are needed to achieve the expected result? The formula for confidence level is expressed in
Microsoft Excel as 1-(1/sqrt(n)), where n is the number of repetitions. Turns out, it takes 400 trades to achieve
a 95% confidence levelthe standard used in medical science. An intra-day trader may commonly generate this
volume of activity in any given year, but most multi-day traders will be hard-pressed to do so. Therefore, be
prepared for drawdowns in trading capitalexpect both good years and bad. On the other hand, it takes only 100
trades to gain a 90% confidence level. One hundred multi-day trades per year is a not an unreasonable goal, given a
suite of short-term systems all using different logic, traded on a number of relatively uncorrelated markets.
In system trading, total return is additive. Dont throw away a good system, simply because it does not yield
impressive annual returns. Consider each model as one part of a larger machine. If your systems are short-term and
valid, then the more systems you deploy and the more markets in which you participate, the larger the return.
Consider a set of systems, each yielding an average return-per-trade (or expectation) of one half of one percent per
trade. Lets say that the set generates 30 trades in one market, and in another relatively uncorrelated market, it
generates an additional 20 trades, and another, 10. Thats 60 total trades, yielding an average total annual return of
30%. Meanwhile, there is an entire industry of money managers struggling to outperform the standard benchmark
the S&P 500, which yields an average of 7-10%, depending on what period is measured.
Diversification is the most common way that investors take advantage of the law of large numbers. Diversify across
markets, methods, and time. Trade a number of systems, each based on different logic. Trade at least three
somewhat uncorrelated markets. Choose markets that zig when the others zag. Choose markets that respond
differently to events. Variety smoothes the overall equity curve, and to the extent that trades overlap, a degree of
hedging may be enjoyed. Such diversity provides a measure of protection against catastrophe.
Undisciplined leverage negates the law of large numbers, because too much risk is placed on individual trades, and
too much capital is tied up in a few trades. Be a plugger, not a plunger. As in baseball, a strong batting average
is achieved by emphasizing singles and doubles and letting the occasional home runs come as unexpected delights.
Try to hit as many singles as possible.

BUILDING A SYSTEM - JONELIS - 3

Measure and Control Risk

Use Fixed Fractional Money Management. It is both highly effective and easy to implement. The method defines
risk as the percent of trading capital that is acceptable to lose if a trade stops out. Simply determine an appropriate
percent to risk on each trade, and then manipulate the size of each trade to achieve the same risk every time. As the
account grows, trade size increases. As the account draws down, trade size diminishes. The percent risked stays the
same. There are two good books on the subject by Thomas StridsmanTRADING SYSTEMS AND MONEY
MANAGEMENT (ISBN 0-07-140019-2) and TRADING SYSTEMS THAT WORK (ISBN 0-07-135980-X).
One can be more precise, but as a general rule, never allow open-trade risk to exceed 2% of the trading account on
any one trade or combination of trades in correlated markets. In other words, dont risk 2% of your account on the
S&P 500 and 2% on the Nasdaq at the same time. Even though these two markets are different in volatility and
persistence, both will tank simultaneously given a major catastrophe. If you adhere strictly to this rule, even a string
of twenty consecutive losses will not cause your account to blow up.
Use Monte Carlo analysis to measure the risks of any given system or set of systems. For help in using this tool
without a degree in math, see my lead article, ALTERNATE HISTORIES in the JOURNAL OF TECHNICAL
ANALYSIS (2005, Issue 63, Market Technicians Association). That paper started as a presentation to this group.

Beware of Circular Thinking, Coding Errors, Clairvoyance, Compexity and Curve Fitting
Circular ThinkingSolitude permits introspection but does not breed ideas. Left alone, one tends to think in
circles. Ideas are neededlots of ideasoff-the-wall ideas. I highly recommend collaborating with others. Ideally
one would seek the following attributes: 1.) Creative thinkers with completely different modes of thought. 2.) The
ability to work as a unitthrough brainstorming, division of work, and mutual kindness. 3.) The integrity to respect
the intellectual property rights of the team. I realize that such a list may sound hard to fill. I have been fortunate.
My own research group consists of an individual with a gift for teaching and spotting errors, a statistician, an
experienced technical trader, and me. None of us are programmerswe stretch ourselves to accomplish the task. It
has taken three years to develop our current crop of systems. But I have never before been involved in a project that
provided so much in the form of creative challenge, reward, and outright fun.
Coding ErrorsModel building requires programmingat least to a limited extent. Writing code inevitably
yields errors. Just as nobody should be expected to proof his own essay, so in like manner, a system developer
should not have to proof his own concepts and code. Its a formula for frustration and stagnation.
ClairvoyanceStrange as it may sound, this is a constant problem facing the system developer. Simply stated,
clairvoyance is allowing a system to take advantage of information that would not yet be available in a real trading
environment. Ill give just a few examples:
Indicators that calculate at the Close, while the system executes intra-day
Execution at the High or Low of a bar
Mismatches between the price at time of trigger and the price specified in the stop-limit field
Whenever test results look too good to be true, the system should be tested for clairvoyance. If you have a real-time
platform, there is an easy way to check for this problem. Simply plot the indicators or signals on a 1-minute realtime chart of a highly volatile and liquid market, and watch for changes in the signal history.
ComplexityThe greater the number of conditions, the higher the degrees of freedom. In other words, each
added condition tends to randomize test results and more iterations are needed to maintain the same statistical
significance. Taken from a practical perspective, the real goal is to generate a lot of trades per year. Too many
entry conditions reduce the number of trades, because each new condition makes the trigger more exclusive. On the
other hand, the more exit conditions, the sooner the trade is terminated, potentially increasing the number of trades.
I favor simple entries and complex exits.
Curve FittingThis is probably the number-one plague on the population of system developers. As an analogy,
the higher order a regression, the closer it fits an existing data set. But often, the higher order the regression, the less
its predictive value. An illustration: Sometimes a tightly fit regression will predict one outcome with remarkable
accuracy, and then on the next several iterations, will choose outcomes that are wildly wrong. On the other hand, a
simpler regression may never provide accuracy, but may tend to land in the general vicinity on a more consistent
basis. So it is in building systems. Often, the closer a model fits a data set, the less predictive it will be. Since the

BUILDING A SYSTEM - JONELIS - 4

characteristics of any future data stream are known only by inference and subject to abrupt change, I recommend the
value of the blunt instrument. The first step is to recognize that, to one degree or another, all trading methods are
curve-fit. The goal is to create one that isnt too tight. A system is called robust, when it works, in general, across
a variety of market conditions. It is unspectacularwhat might be called, good enough.
Steering away from over-fitting the curve is as much an art as a science. Permit me to point out three avoidance
techniques:
The MetaStock handbook recommends testing across the oldest half of a data set, then validating across
the remainder of the data. This is a very simple example of out of sample testing.
In my last presentation on this topic, I described an established and elaborate method known as the Walk
Forward Test, complete with descriptive chart. Basically the Walk Forward involves optimizing a system
across a defined chunk of data, then testing out-of-sample on the next chunk. If the out-of-sample test
verifies the model, then the process is rolled forward and repeated. Then again, and so forth. Using this
method, a system can be kept in phase with changing market conditions on an ongoing basis. Walk
Forward Testing is, I believe, still the industry standard. But it is elaborate and time consuming and there
is some question as to whether or not it is the best solution to the problem.
The method that I currently use is simple. Apply lots and lots of data, and to use all of itright up to the
most recent sets. For out-of-sample testing, I simply put aside the data from one of the markets that I hope
to trade. Many will disagree, but I believe that this provides a rigorous test. Permit me point out the
advantages of this approach. It relies on three simple ideas.
New data is important because the system must work in current market conditions.
Old data is important because market conditions change.
A system should perform well across both old and new data.
Most of my methods take the Long side. Starting in March of 2000, the US equity markets went into a
protracted bear run. For the system developer, this is an unusual opportunity. If an idea works during the
bullish phase, which represents the bulk of the dataand also during the bearish phase, which is the recent
datathen it is likely a robust solution.
But let each researcher choose the method that seems appropriate.

Design a System that Suits You

A system is useless if it does not match your personality. Do you want to be right most of the time, or do you prefer
to avoid adverse price moves? At the extremes, one approach might provide many small winning trades at the
expense of a few large losses, while the other might result in numerous small losses and only a few big gains. In
general, the degree of probability and the reward to risk ratio display an inverse relationship. You must find the
combination that suits your personality or you will be unhappy with the result. There are many other issues to
consider. For example, will you ignore the trade during the day, or will you watch it in real-time? What time frame
do you prefer? Are you an introspective or a reflexive thinker? Are you a thrill-seeker or risk averse?
There are purely discretionary traders, who do their analysis on a case-by-case basis. There are purely nondiscretionary traders, who make all decisions in advance, trading purely by rules. In truth, most fall somewhere inbetween. Who is right? I have to admit that I know traders who make money in many different ways and I cannot
find cause to condemn any of the approaches. I think the question boils down to game playing. Do you like a good
hand of poker, or do you prefer chess? If you like a fast-paced round of cards, you may make a good discretionary
trader. But if you prefer to sit back and ponder a chessboard, consider the advantages of a non-discretionary system.
A systems approach allows you to calmly make your decisions in an abstract environment and apply statistical tests.
Execution can be purely mechanical, with workdays spent creating more strategies. But remember, to receive the
advantage-as-tested, one must follow the system and not fiddle with it on the fly.
To read about system development in storytelling form, I recommend the wonderful book, THE PREDICTORS by
Thomas A. Bass (ISBN 0-8050-5757-9). Model builders will find this book a joy. I found in it a much-needed
source of encouragement.
Now lets move on to a practical demonstration. We will conceive the most basic strategy possible, build a simple
model, and then test it, and determine whether or not we want to trade it.

BUILDING A SYSTEM - JONELIS - 5

BACKTESTING 101
Following are illustrated demonstrations of certain basic functions in Equis MetaStock Professional version 9.
These functions are foundational to those wishing to take full advantage of the MetaStock platform. Please make
sure you have a firm grasp on the 101 materials before moving to 201. This demonstration is designed such that the
reader can practice the exercises by following along. Bear in mind that what is shown is only one of many ways to
use this large and complex software package. It is assumed that the reader has a basic familiarity with the program.
These procedures do not replace the official manual. Rather, it is hoped that this demonstration will serve to
shorten the learning curve. If errors are encountered, please refer to the manual, and contact the group so that
corrections can be made.
Create an Indicator
Before we move on to systems, it is important to know how to write custom indicators. We will create a Displaced
Linear Regression, called DLR Rapid. Click the

F(x)

icon as shown. This is brings up the Indicator Builder.

Click F(x) at the top

of the chart display.
This will bring up the
Indicator Builder.

Click New. The Indicator Editor will appear (see background box above).
Type in some meaningful name. (Ill call it DLR Rapid)
Click Functions and a list of indicators will appear (see foreground box above).
Select Linear Regression Indicator.
Check Paste Arguments in the lower left corner. Click OK.
Your indicator will appear in the editor, (see below):

Function with Arguments Displayed

Insert values and apply Ref() function

A linear regression function comes up with instructions pasted in the window (above left). Simply replace the text
with the desired values, as follows: The values are LinearReg(L,10,S,10). A high degree of smoothing has been
chosen so that the indicator will show a definite direction and not jiggle around. This is an important consideration
when using an indicator in a systemit helps prevent a series of quick reversals. One needs to be definite. Next,
type-in a Reference function to displace the indicator 3 bars to the right, as in Ref(LinearReg(L,10,S,10),-3). Click
OK. The indicator will appear in the Drag and Drop box. Drag the indicator onto the price window.

BUILDING A SYSTEM - JONELIS - 6

Create another indicator:

Scroll down to PS StochRSI. Click Copy.
Name the copy. (Ill call it 8 StochRSI 10)
Click Edit and remove the last two items of code.
20;
80
(The 20 and 80 are horizontal reference lines, which
prevent the function from being used in a backtest.)
The PS StochRSI is part of the Performance Systems
Plus plug-in. MetaStock has granted permission to
post the StochRSI code in this paper. Our change
results in the following function:
(Sum(RSI(10)-LLV(RSI(10),10),3)
/Sum(HHV(RSI(10),10)-LLV(RSI(10),10),3))*100
Plot the new indicator in a separate window on the
chart, as shown below:

NoteI have chosen this indicator for our workshop

somewhat at random, but also because it oscillates
to extremes, even during flat markets. I hope that it
yields a large number of signals. I have not worked
with it in the past, and look forward to seeing how it
behaves.

The above chart shows the entire display with the custom indicators plotted. Volume is shown in the lower window.
To build a system, our first step is to visualize the strategy on the price chart, using the Expert Advisor.
WarningWe are about to build a simple demonstration system that I call HEART ATTACK. The idea is to
highlight the basic concepts, and not to get bogged-down in programming. This system is intended purely for
demonstration purposes. Use it as a training tool. Please do not trade it.

BUILDING A SYSTEM - JONELIS - 7

Create an Expert
MetaStock is extremely visual. Type a concept in code and the result appears on a chart. That means that concepts
can be written and displayed, much as an artist uses brush and paint. We will begin by creating an Expert.
Click the Man with the Hat icon (top of price display) to bring up the Expert Advisor (background window below).

Expert Advisor dialogue box (background)

Click New to bring up the Expert Editor (foreground).
Enter the name of the system, HEART ATTACK 1.

Entry Symbol
Click the Name tab.
Type in the name, HEART ATTACK 1 BUY
Enter the following defined variable: (Defined
variables are used as a kind of shorthand.)
S1:= Fml(8 StochRSI 10); (note semicolon)
There are three arguments to this entry signal:
Cross(S1,20)function must cross up thru 20%
H>Ref(H,-1)a higher high is also required.
C>5prevents any signals on low priced issues.
Click OK
Simply stated, buy when indicator crosses 20

Select the Symbols tab and Click New (background).

Click the Graphic tab and choose options as desired
(Select symbol type, color, notation, font, and location).

Exit Symbol
Create another Symbol for the exit.
Click New and create another symbol.
S1 is the same defined variable.
Cross(S1,95) says that S1 must cross 95.
The code simply states Sell when the indicator
crosses up through 95. This is our profit target.
Select a graphic and click OK
(The symbol graphics can be serious or fanciful,
whichever you prefer.)

BUILDING A SYSTEM - JONELIS - 8

Bring up Microsoft Notepad. Paste-in the code. Notepad is a good place to write and store code for later use in
various places within MetaStock. Below is the code for our system, as it might appear in Notepad:
BUY--S1:=Fml(8 StochRSI 10);
Cross(S1,20) AND H>Ref(H,-1)
AND C>5

Entry HighlightClick the Highlights tab. Click

New. Copy exactly the same entry code used for the
entry symbol from Notepad. This paints a color over
a bar, in lieu of a symbol. Choose a color. Click OK.

SELL--S1:=Fml(8 StochRSI 10);

Cross(S1,95)

Exit HighlightCreate another highlight for the exit, again

using the exact code as the exit symbol. Choose a color. Click
OK. MetaStock cannot display two symbols on the same bar,
so Highlights will be important later in the procedure

Bring up a chart and right-click in the price window. Choose Expert Advisor, then Attach. Scroll to the Expert
that was just written and click OK. The symbols and highlights should appear on the chart.

The figure above shows the HEART ATTACK 1 system plotted on a chart, with the individual trades boxed-in by
hand for illustration. This is a visualization of the model. Note the way the strategy catches intermediate price
swings and exits on strength. Note also the outsized loss on the left-most trade. From a brief look at this small data
set, it appears that the system is acting as expected, but that more work will be required to make it tradable.

BUILDING A SYSTEM - JONELIS - 9

Create a System with an optimization variable

Click on the

icon at the top of the MetaStock display. The System Tester will come up.
Click New System in at top left.
The System Editor will come up.
Name the system and enter any
notes.
Order BiasClick the Long radio
button. If a Long and Short signal
both trigger at once, the system
will select the Long order.
Portfolio BiasSelect Multiple
Position LimitCheck the box
and enter the number 1.
It may seem counterintuitive, but
this combination will instruct
MetaStock to trade only ONE
position at a time, and keep the
position open until an exit signal is
generated. Entry signals triggered
while a trade is open will be
ignored. Opposing signals will not
cause a stop-and-reverse.

Click the Buy Order tab. Paste-in the Buy code from Notepad.
Order TypeSelect Market
Limit or Stop PriceLeave blank (covered in next workshop)
Entry SizeSelect Use Default Size
ExpirationSelect Good Until Cancelled
Strategic DelaySet these all at 0ALWAYS ZERO.
Click the Sell Order tab. Paste in the Sell code from Notepad.
NOTEReplace 95 with OPT1 as in Cross(S1,OPT1)
All other settings are the same as shown above.
Click the Optimization tab. Click Edit.
The Variable Properties box will come up.
Give the variable a name( Ive called it upper line)
Enter the minimum and maximum values(Try 75 to 95)
Enter the steps between values(5 is enough granularity.)
Click OK
Click OK again to close the System Editor.
The HEART ATTACK 1 System has been created.

BUILDING A SYSTEM - JONELIS - 10

Test the System

Now lets test this strategy across a diverse set of equity indices.

Click on the $ icon to bring up the

System Tester. Scroll to the system,
HEART ATTACK 1 and highlight.
Click New Simulation (bottom of
background window). The Select
Systems dialogue box will appear.
Verify that the correct System is
selected and click Next. The Select
Securities dialogue box will appear.
NOTEIt is recommended that all
tests use Local Data stored on the
hard drive, as opposed to streaming
Real-Time data.
Click Next to bring up the Select
Securities box.
Click Add Securities and browse
to the file of choice. Select a
security and click Open.
Highlight the security and click
Dates. Enter the date range. (I will
use 7/22/1965 to 7/22/2005.) Click
OK and enter another security.
When all the securities are entered,
click Next to bring up System
Testing Options.
For demonstration purposes, we will
restrict this test to readily available
data. (Ive entered the S&P 500 and
Dow Industrials from 1965 to 2005,
using data from TC-2000, which I
have rounded off to the nearest tick
size.) That will test the strategy
across a variety of conditionsfrom
range-bound to strongly bullish to
strongly bearishfrom persistent to
choppyfrom sleepy to volatile.
Ill add the Nasdaq (from 1990 to
2005) to make the test more
rigorous. The Nasdaq is more
volatile than the other markets, and
the period chosen is at least onethird bear market. This should prove
a difficult test.

MetaStock is capable of testing

multiple systems against multiple
securities. Because of this, we can
obtain the average result of all
markets tested. This is crucial to
creating a robust system.

BUILDING A SYSTEM - JONELIS - 11

In System Testing Options, set Initial Equity to 100,000.

This will make all the performance numbers easy to
interpret.
Set Default Size to % of Available Equity, enter 100.
This will force the size of each trade to be equal to the entire
account. This way, disparate securities will be readily
compared on equal footing, and all our tests will run to full
term..
Use other settings as shown. For this test, we will
uncheck the Quick Test box, so that the system will keep a
log of each trade. We will need that for our proof at the end
of the procedure.
Click More to bring up Broker Options.
MetaStock does a good job of making a simulation feel
like real-life trading. But its important to understand
that it is not the same as real-life trading. There is
nobody on the other side of the trade reacting to what
you are doing. In the simulation world, Market Orders
are just as good as Limit Orders. All trades are filled
at the correct price, every security has unlimited
liquidity, and position size is unbounded. In the
simulation world, futures have no leverage and all that
is known is the price on the chart. Certain matters
need to be viewed as if in a mirror.

Click OK, then START. The simulation will run.

In the Broker Options tab, set Margin and Money Market

interest rates both to zero. We are testing a system, not an
estate plan.
Set Margin requirements as shown: Long Initial = 100,
Long Maintenance = 0, Short Initial = 200, Short
Maintenance = 101. With these settings, each trade will be
sized at 100% of remaining equity, and positions will be
unleveragedmargin will be used merely as overdraft
protection. Each test will run to full term, even if it loses
money. Also of importancevalid signals will not be
refused for brokerage reasons.
CommissionsInclude both commissions and slippage in
these windows. Select Percent of Transaction (%). To test
futures, calculate your actual commission costs and add the
cost of at least one tick to both sides of the trade to simulate
slippage, then convert to a percentage and round up. To test
stocks, either calculate a percent, or select Points per Unit
($) and enter the actual commission per share plus slippage
of from 1-5 cents per share for both sides of the trade.
In the Trade Execution tab, UNCHECK Realistic Market
Prices, and set Delay order opening to ZERO. All sorts of
unexpected problems occur when testing using a delay.
Program your order delays into your code.
Set Buy, Sell, Short, & Cover Prices to Close or Open.
Keep in mind that most indicators calculate at the close.
(Please do not use High or Low.) These will be your
defaults. A limit price (see Section 201) will override the
default, giving you a lot of flexibility, as will be seen later.
Do not enter slippage under Slippage. This creates
unexpected order problems. Add slippage to Commissions
as mentioned above. That way, your execution price will be
precise, and your slippage will be booked against your
account as a line-item entry.

BUILDING A SYSTEM - JONELIS - 12

When finished, click View Results. Because we used an OPT variable, a summary page is generated comparing the
net results, using each value. In my opinion, this page gives the most valuable information in the entire package. It
shows the AVERAGE RESULTS ACROSS ALL MARKETS TESTED AS AN AGGREGATE. Even when not
optimizing for a variable, a dummy OPT variable can be created so that this page will be generated.

For now, without getting complicated about it, we will choose the highest return, which turns out to be a StochRSI
value of 95. Note above that an average of 229 trades per market were generated. A quick calculation will reveal
that 72% of them are winning tradesa spectacular result. However, there is a glaring defect in this solution. Can
you detect it? (We will address that question in Section 201.)
Double Click on the line showing OPT1 as 95. Individual results for each market will appear, as follows:

Each market is shown at the value of 95. Why did the Nasdaq do so poorly? Actually, it didnt. Its test merely
contains fewer years of data. It is important not to attach too much importance to the height of the bars. But since
the Nasdaq is our most volatile market, lets take a closer look at it.
Double click on NDX, and a number of reports will come up.

BUILDING A SYSTEM - JONELIS - 13

Reports for NDX

Click on the Equity tab. A cumulative equity line is drawn for the NDX. Not a pretty sight. As it stands, I would
not want to trade this system.

Select the Positions tab (see below). This is a record of every trade, and plots the frequency of each trade result
on a percentage basis. The more heavily weighted to the right of zero, the more robust the solution. This chart
highlights the strength of this particular strategy.

BUILDING A SYSTEM - JONELIS - 14

Click the Summary tab. The page includes analysis of various types.

Some of the interesting numbers include annualized performance, comparison to buy-and-hold, highest and lowest
profit and loss, most consecutive losses, maximum position excursion, highest open-trade drawdown, highest
closed-trade drawdown, Maximum, minimum, and average trade length. There is a wealth of information on this
page, but again, these numbers represent only one security tested on one data set. We will analyze of aggregate
results in Section 301.

BUILDING A SYSTEM - JONELIS - 15

Click the System tab. All the system details are recorded here. This is global informationidentical for every
OPT variable, security, and data set used in the test.

This page includes everything needed to reproduce the test, including trigger code, brokerage settings, and limit
price formulas. (Limit prices are covered in Section 201). Code can be copied directly from this page and pasted
into Notepad or Excel (see Section 301). Next, click Plot to Chart (lower right corner).

BUILDING A SYSTEM - JONELIS - 16

Click Plot to Chart, and CLOSE THE SYSTEM TESTER. The trades are plotted directly on the chart of the
NDX. Now bring up the Expert that we wrote, using the Highlights (not the Symbols) for BUY and SELL. (The
boxes are drawn by hand for clarity.)
Do the colored highlights match what the system as plotted? They do. By holding the cursor over each trade
number, the execution price is displayed, and can be compared to design expectations. This is a proof that the test
performed as expected.

Conclusion to Section 101

Up to this point, we have conceived a strategy, written an indicator, visualized a model, tested it, and proven the test.
Next, we will perform intra-day execution on daily bars using limit orders.

BUILDING A SYSTEM - JONELIS - 17

BACKTESTING 201
In this section, we will use limit orders to perform intraday trade execution on daily data. Further, we will backtest
in a way that takes into account the overnight gap. Understanding of the 101 material is essential to practicing the
following procedures. The examples are simple, but the concepts may open the door for further exploration.
In Section 101, we created a system that resulted in winning trades 72% of
the time, and I pointed out that the solution had a glaring defect. The
Avg. Profit/Avg. Loss or Reward/Risk (R/R) was a dismal 0.59. In
other words, the strategy made (on average) only 59 cents for every dollar
risked. I like to see R/R in the 1.60 to 2.00 range, but Probability and R/R
are typically inversely correlated. Digging deeper, it can be shown that
the maximum open-trade drawdown was 34%. This is essentially
undefined risk, much like buy-and-hold, and does not come under the
category of disciplined trading. Clearly, more work must be done. We
may or may not achieve a tradable system within the limits of these notes,
but armed with the concepts shown, and using individual creativity, it is
hoped that each reader will find a unique solution.

To test for maximum open-trade

drawdown (single trade) perform a
simple optimization, as follows: In the
System, go to the Stops tab, and enter
OPT3 in the Maximum Loss function.
Click the radio button Percent. Under
the Optimizations tab, set a range,
such as 1 to 50 in increments of 1.
Run a test and scan the results for the
point at which the output shows no
change. The OPT3 value at that point
is the maximum open-trade drawdown.
For Heart Attack 1, it turned out to be
34%, which gave rise to its name.

Create an Adaptive Stop Loss

When testing multiple markets across wide time frames, it is useful to create a stop loss indicator that adapts to the
local volatility of the issue being tested. If the Stop does not adapt, then a different value will be needed for each
security, and the Stop value will have to be adjusted over time. We want one number that works across a broad
selection of data. To make the function adaptive, we will use a multiple of the 20-period Average True Range, or
ATR(20). This will be a Chandelier style stop loss, which hangs from above.
{8 Heart Attack Stop Long}
J:=0.6;
R:=ATR(20)*J;
S1:=Fml("8 StochRSI 10");
Y:=Cross(S1,20)
AND H>Ref(H,-1)
AND C>5;
Stop:=ValueWhen(1,Y,H-R);

Stop
(The J value of 0.6 is chosen at
random. Performance testing will be
done in section 301.)

Y is simply a defined variable describing our entry condition.

By including this in the indicator, the stop will re-set each time a
trade is triggered. Because the stop automatically resets, it can be
used in a backtest. Because it is based on the Average True
Range, it will adapt to local conditions.
NoteMetaStock treats anything in {brackets} as a remark. In
this case, brackets allow inclusion of the title of the indicator.
We have already covered creating an Indicator. All Indicators,
Experts, and Systems can be written and saved in text form.
Microsoft Notepad gives us a convenient workspace and an
efficient way to catalogue such material.

The stop loss function is shown plotted on the chart below. It plots a value J units of ATR below the High on the
day-of-entry, and re-sets at each new entry signal. Plot it on your own chart along with the Expert to verify that it
works as intended. The indicator should appear as shown.
This is a simple and basic stop loss, which carries with it
a limitation: If a new trade signals before the previous
trade closes and the market is in a downtrend, then it is
possible that the stop will back off. However, this
should not prove a problem, given a J number that is
tight enough. In any event, the intent is to demonstrate
the use of a limit order. Complex stops are outside the
scope of these notes. (For examples of complex stops,
please explore the websites listed at the end of this
paper.)
If one prefers a trailing stop to a floor, simply replace
the ValueWhen() function with HighestSince().

BUILDING A SYSTEM - JONELIS - 18

Test the Stop Loss

Bring up the System Tester and copy the system, Heart Attack 1. Name the copy Heart Attack 2. Change the code
as follows:
{SELL ORDER}
J:=OPT2;
R:=Ref(ATR(20),-1)*J;
S1:=Fml("8 StochRSI 10");
Y:=Cross(S1,20)
AND H>Ref(H,-1)
AND C>5;
Stop:=ValueWhen(1,Y,H-R);
Cross(S1,OPT1) or L<Stop

Note the last line (shown in bold). This code will trigger a Sell if the
indicator signals a Profit Target or if the Low violates the Stop Loss
price. Either condition will trigger an event.
The ATR is referenced back one day. When writing stops, this is a
good precaution to prevent clairvoyant exits. Similarly, our indicator
calculates at the Close, so our entry must wait for the Close (or the
Open of the following bar).

Limit Orders
So far, any Sell trigger will execute at the default value, which we have set at the Close of the day. Lets tell
MetaStock to enter at the Close, but execute the Stop on an intraday basis. To do this, we will use a Stop Limit
Order. Click on the Sell tab and select the radio button Stop Limit. Click on the f box to bring up the Formula
Editor. Enter the following code:
{STOP LIMIT}
J:=OPT2;
R:=Ref(ATR(20),-1)*J;
S1:=Fml("8 StochRSI 10");
Y:=Cross(S1,20)
AND H>Ref(H,-1)
AND C>5;
Stop:=ValueWhen(1,Y,H-R);
If(L<Stop,Stop,C)

This is identical to the Sell Trigger code shown above, except for the
last line (in bold). Only the Stop condition is needed herenot the
Profit condition. The IF statement in the last line says the following:
Whenever the Low crosses the Stop, execute at the specific price,
called Stop. But if any other condition triggers, execute at the
price at Close. (And if nothing triggers, do nothing.)
The limit price formula is ignored until an event is triggered.
Keep in mind that the Sell Order field executes the trigger, while the
Stop Limit field (shown here) merely defines the price.

Accounting for the Gap

What if, during a trade, the market opens below our Stop?
{STOP LIMIT}
J:=OPT2;
R:=Ref(ATR(20),-1)*J;
S1:=Fml("8 StochRSI 10");
Y:=Cross(S1,20)
AND H>Ref(H,-1)
AND C>5;
Stop:=ValueWhen(1,Y,H-R);
If(L<Stop
,If(O<Stop,O,Stop)
,C)

At right, the Stop Limit code is shown

in the Formula Editor (foreground)
and the Sell code is shown in Sell
Order field (background).

The Buy Order will be the same as in

Procedure 101 (see below).
{BUY ORDER}
S1:=Fml("8 StochRSI 10");
Cross(S1,20)
AND H>Ref(H,-1)
AND C>5

Again, change only the command line at the end (shown in bold).
It states the following:
If the days price violates the Stop,
a.) If the Opening price is below the Stop, execute at Open
b.) If the Open is not below the Stop, execute at Stop
If any other Sell trigger occurs, execute at price Close
If no trigger occurs, do nothing.

BUILDING A SYSTEM - JONELIS - 19

Setting the range of the OPT variable

We will perform optimizations in Section 301. For now, set single values for each of OPT1 and OPT2, so that a
summary page will be generated. Click on the Optimizations tab, then EDIT, and set the parameters for OPT2:
DescriptionUpper Line
Minimum95
Maximum95
Step5

DescriptionJ
Minimum0.06
Maximum0.06
Step0.02

Proof the Model

Run the test (with details) and click on one of the data sets.
Click Plot on Chart.
CLOSE THE SYSTEM TESTER.
Close (or reduce in size) the Equity Window (upper window of chart) and zoom in.
Bring up the Expert from Procedure 101. Create a new Highlight, and enter the code from the Sell Order tab:
{EXPERTHeart Attack 2 SELL}
J:=0.6;
R:=Ref(ATR(20),-1)*J;
S1:=Fml("8 StochRSI 10");
Y:=Cross(S1,20)
AND H>Ref(H,-1)
AND C>5;
Stop:=ValueWhen(1,Y,H-R);
Cross(S1,95) or L<Stop

NoteAn optimization value cannot be used in an

Expert. When creating an Expert Highlight,
hard-code the OPT value that matches the value from
the testin our example, 0.6 and 95 (each
shown in bold).

Activate the existing BUY and the new SELL Highlights, and uncheck all other Highlights and Symbols.
Plot the Stop Loss, and make sure the J value for the Stop function matches the test value of 0.6.

Hold the curser over a few BUY and SELL symbols and read the price logged by the System Tester.
Compare logged entries to those plotted on the chart.
Do the Entries and Exits occur at the Close, as intended? They do.
When a bar crosses the Stop Loss, is the correct intra-day price logged? It is.
When price gaps below the Stop Loss, is the Opening price logged? Yes.
Conclusion to Section 201
Up to this point, we have created an adaptive stop loss, plotted it on a chart, and changed our system to execute
intra-day by use of limit orders. We have accounted for the overnight gap, tested the model, and proofed the test.
Next we will move outside of MetaStock to analyze our data.

BUILDING A SYSTEM - JONELIS - 20

BACKTESTING 301
In this section we will move our data out of MetaStock and into Excel. Once the data is on the spreadsheet, we can
sort it, analyze it, compare it, and store it. Bring up the previous simulation for Heart Attack 1, or run a new one.
The optimizations
page (at right) shows
the average
performance of all
markets. (This page
was generated because
we included an OPT
variable.)
Right-click on the
numbers, then Cutand-paste into Excel.

A MetaStock technical representative

once told me that people complain that
this page doesnt contain enough
information. Actually, it displays the
best and most important information
put out by the program. It shows the
average results of all markets tested.
But we need to unlock the numbers.

Note that column F (6th from the left, above) is a fraction. The secret to unlocking the data is to delete the
denominator. Even if faced with pages and pages of optimization results, all denominators can be deleted
simultaneously. Highlight the column, and use Excels [CNTL H] function.
The next problem is that the original numbers are compounded on a trade-by-trade basis. When using long runs of
data, this magnifies performance to unrealistic heights. Unless you are trying to dazzle unsuspecting customers with
big performance numbers, you really would rather know the average return in any given year, independent of other
years. We will change the compounding to simulate starting with the same account size every year. The change is
accomplished using the Log Normal or LN() function in Excel.

At right is an example
of a performance
numbers that can be
gleaned from the
seemingly meager
program output. The
sophistication of the
analysis is up to the
individual.

The reader will recognize that many other statistics (and even full-color graphs) can be brought out from the same
original output. My focus is on three numbers:
1.) Avg % Gain Per Trade (A pure comparative number, this is the average of all wins and losses.)
2.) Probability (A measure of how often one can be expected to land on the right side of a trade.)
3.) R/R (A measure of how much, on average, one can expect to profit for every dollar put at risk.)
(During the workshop presentation, I demonstrated a way to describe the aggregate equity curve, using two rough
numbers, as well as some comparisons to buy-and-hold. These have been omitted from the notes for simplicity.)

BUILDING A SYSTEM - JONELIS - 21

Next, lets perform an optimization of Heart Attack 2, then move it into Excel and sort it. As can be seen, all the
code needed to reproduce the System, Expert, and Indicators can be stored along with the test results in Excel:
At left is an optimization of Heart
Attack 2, testing both variables. As
is shown, R/R can be brought above
1.00, but at a bitter cost to all levels
of performance. Stops of J=2 or
tighter may be seductive, but in this
strategy, they throttle the trade.
Its a good thing we tested before
trading. As it stands, the concept of
limit orders has been demonstrated,
but a tradable system has not been
shown.
We cannot further loosen the stop,
because our simple function may
back off during a bear market. A
complex stop is needed for the
testone that will permit more
room for the trade to breath, without
the danger of backing off. For
instructions on writing complex
stops, see the websites at the end of
these notes.

Lets turn back to Heart Attack 1

and see if we can find a
reasonable defined risk level for
money management purposes.
We will optimize using
MetaStocks built-in percent stop.
In the System, under the Stops
tab, find Maximum Loss. Check
Long, select the Percent radio
button, and enter OPT3 to test for
an end-of-day stop level. Well set
our range from 8% to 20% in
increments of 1%.

For demonstration purposes,

16% appears to be a sweet spot
on the optimization (see
highlight at right). In actual
practice, this type of stop must
be tested individually for each
market, and continually updated
to account for recent volatility.
As is shown, overall
performance is reduced slightly
from the original version.
(That one had an alarming 34%
open-trade drawdown.) The
percent stop may be
primitive, but it at least allows
us to define our risk, and limit
the size or each trade to control
our maximum loss.

Lets take a closer look at Heart Attack 1b. Next we apply the Monte Carlo
simulation.

BUILDING A SYSTEM - JONELIS - 22

Monte Carlo Simulation

For a detailed procedure on setting up and reading an MC simulation, see the article ALTERNATE HISTORIES
(reference at end of paper). For our engine, well use Equity Monaco from TickQuest. At date-of-writing, it is a
free download. One additional wrinkle is added for this testeach trade is normalized to the same account size.
Run the System Test againthis
time with details. Go to the
Positions tabs in the System Test.
Cut and paste the data (not the
graph) into Excel. The three
columns at the right are added to the
spreadsheet as follows:
EQUITY
=IF(B__="Total",I__+H__,"")
% CHANGE
=IF(B2131="Total",(I2131I2123)/I2123,"")
MC INPUT
=IF(B__="Total",J__*$_$_,"")

($_$_ refers to the cell containing

initial equity. The titles are for
illustration. Do not enter titles.)
As can be seen, Position # 262
results in a $5,407 gain, which is a
0.9% percent change in equity,
which at this point in the simulation
is over $500,000. This is raw
MetaStock output, and compounding
has not yet been removed. In terms
of the initial equity of $100,000,
0.9% is about $920. The $920 is the
gain normalized to initial equity.
Copy the last column to a text file for
use in our MC simulation.

The MC equity plot

displays a strongly
positive slope and forms
a nice distribution around
the mean. But of 300
paths, many experience
a 50% drawdown, and
one outlier leads to ruin.
A look at the numbers on
the Y-axis reveals that
terminal equity is quite
widely scatteredfrom
about $150,000 to
$700,000. This is not the
kind of result one wants
to see in a systematic
trading strategy.

BUILDING A SYSTEM - JONELIS - 23

The Position Data is

strongly skewed positive.
This graph points out the
strong points in the model,
much like the graph on the
MetaStock Positions page
(see section 101). There is
certain robustness to it.
It is clear that this strategy
has aspects that show
merit.

There are 7 consecutive

losses at the 95th percentile.
(see arrow) At first glance,
this seems a rather typical
result.
But this particular strategy
can lose as much as 16% in a
single trade. If it were not for
the fact that our money
management strategy
reduces position size as
equity draws down, seven
consecutive loses could lead
to ruin.
In actual trading, we would
reduce position size to control
risk, but that would come at
the cost of reduced profits.

The high variance in terminal equity shows us the nasty side of this system. Of particular concern is the 16% opentrade-drawdown. It will be difficult to trade the strategy within any reasonable risk profile. This is the kind of
system that entices you with a lot of small gains, and then clobbers you with a huge loss. As it stands, I will not
trade the current versions of Heart Attack. That decision defines reason I perform tests.
I still hold out hope that the adaptive intraday stop will transform Heart Attack 2 into a tradable strategy, and I
leave that to the group. What is needed is a complex stop loss function that includes a latch to define whether or
not a trade is open. (Instructions for writing such a stop are referenced below, but the code is outside the scope of
this workshop.) The basic concepts have been demonstrated, but it is left to the reader to find a personal and unique
solution to the system.
Conclusion to Section 301
In this section we moved our test results out of MetaStock and into Excel. We removed compounding from the
numbers and applied an array of statistics. We performed a Monte Carlo simulation using Equity Monaco, and
analyzed the report. That resulted in the decision not to trade Heart Attack until the risk can be better controlled.

BUILDING A SYSTEM - JONELIS - 24

Websites
The following websites have been brought to my attention because of their relation to MetaStock.
I post this list at the request of the group but cannot make any specific recommendations or endorsements:
In the MetaStock world, two names have repeatedly been pointed out to me as highly respected for the quality of
their work. Roy Larsen is one of them. His newsletter is essentially a high-level course in MetaStock programming.
Sample issues are available for download, and the entire set, including back issues, can be purchased in PDF format.
http://www.metastocktips.co.nz/
Jose Silva is the other individual referred to me by so many sources. His site includes many free formula solutions:
http://www.metastocktools.com/
The following newsgroup has some highly sophisticated postings. Roy Larsons Forum.dll and instructions are
available as a free download on this site. To access the materials, first join the Yahoo group. Then go to Files/Equis
Forum DLL and find Forum.dll (rlarsen_99) http://finance.groups.yahoo.com/group/equismetastock/
The MC demonstration was done using the Equity Monaco package, which at time of writing is a free download
from TickQuest. http://tickquest.com/
For a primer on MC, see the pre-print draft of my article for the Journal of Technical Analysis, 2005 Issue 63,
Market Technicians Association, Inc. at my resource site. Go to
http://home.comcast.net/~countertrender/Countertrender.html and select ALTERNATE HISTORIES to download
the PDF file.
For examples of a complex stops, visit Larsen, Silva, or our open forum at http://project301.blogspot.com
Acknowledgements
Special thanks go out to those who have collaborated in my efforts so unselfishly, including Bob Jonelis, David
Jonelis, and Charles Warren. Thanks also go out to Joe Blazie, who has led the Chicago Area MetaStock Group for
years, and also to his counterpart at the Chicago chapter of the Market Technicians Association, Ross Leinweber.
Each has provided a wonderful resource, and both deserve the gratitude of all traders who have been fortunate
enough to participate in their forums.
Credit is given to MetaStock / Equis International and TSA Group. MetaStock, Equis, OptionScope, and
QuoteCenter are registered trademarks of Equis International. Achelis Binary Wave, The DownLoader, Expert
Advisor, The Explorer, Visual Control, and Smart Charts are trademarks of Equis International. Equity Monaco is a
product of TickQuest, Inc. All daily data used in this workshop is from TC-2000, a product of Worden Brothers,
Inc. Excel and NotePad are products of Microsoft Corporation.
Limitations
The comments, procedure, and other information are presented to demonstrate one method of backtesting using the
MetaStock platform. It is hoped that others will add to what has been presented. The material is for educational
purposes and is not intended as investment advice. Permission is granted the reader to generate one copy for
educational use.
This paper is not an exhaustive treatment of the topic. There are no guarantees, and all traders should be prepared
for the unexpected. This author has been known to make errors and reach erroneous conclusions. No doubt, some
of that has crept into this paper.
These notes are a transcript of two workshops given to the Chicago Area MetaStock Group, and are intended for the
use of that group. If any errors are encountered, please contact the group so that corrections can be made:
MetaStockUserGroup@Hotmail.com or visit their website at www.elbsoftware.com/metastock/
About the Author
John Jonelis has been an artist, inventor, corporate vice president, and has served on the boards of two companies.
His paintings are represented in various museums and private collections, he holds seven US patents, MBA and
BFA degrees, and has been published in technical journals and websites. He is currently writing a novel while
building and trading systems with his private research group. Other papers by this author can be accessed at the
resource page, http://home.comcast.net/~countertrender/Countertrender.html