Thoughts on the Kase Dev-stop

Robert wrote:

Thanks for the time and effort you put into your website. It is of great encouragement to me that I am heading in the right direction. . . .Recently I concluded that I needed to develop and maintain a list of high price-high range stocks to trade and backtest. So your latest articles are of great interest to me. I am considering your PowerTools for eSignal and am curious to know does it use volatility outliers to initiate entry signals? I assume it uses something similar to Kase’s dev stop to reverse. Are you familiar with her work and what is your opinion of it? Keep up the good work.

I attempt to answer every question that comes my way, and once in a while, it takes a great deal of effort to hunt down the answer. And this is going to be a long one.

First of all, I am only familiar with technical indicators in terms of how they can be represented graphically; that is, I plot the information as lines, dots, histograms and color bars in ways that make intuitive sense. A familiar look and feel makes the tools easy to use. And that is where the similarities end.

What goes into the calculations is another matter. You might be surprised, but I actually know very little about technical indicators. Why? Because most of the work would not pass muster due to conceptual and procedural flaws. If you want to kill a quant with laughter, just show him a bunch of canned equations from a charting program.

The Kase Dev-Stop

Most traders set stops based on what they can afford to lose. For example, if the trader can afford to lose $5,000, he might trade 10 contracts and risk $500 per contract. This is fine if the typical fluctuations in the market and in the time-frame he is trading are less than $500, but what if they are not?

A trader who sets stops with such assumptions is like a sailor with a small boat who stands by the sea and commands that the waves be no higher than two feet because that is all his boat can handle. When he sets sail into four-foot seas, he is instantly capsized. Like the sea, the market doesn’t care how big a boat is. If the waves in the sea or the risk level in the market is too great to withstand an average trading day without getting stopped out, the trader does not belong in that market. On the other hand, when trading in such a market, a trader should not set stops that will force him out on noise, regardless of whether the trade might have been profitable. — Trading With The Odds: Using the Power of Statistics to Profit in the futures Market, Cynthia Kase

Each market and time frame has its own noise level, and a trader’s stop must be set above it. I can’t agree more.

It didn’t take long to find the specs [DOWNLOAD PDF] for the Kase Dev-Stop. I was disappointed to find that the work was not done according to standard exploratory data analysis procedures. Example: any time we measure something, it should be done in units that allow apples-to-apples comparisons. Another example: the standard deviation of a probability distribution known to be non-normal is of little use.

If we subject similar indicators such as Bollinger Bands and Hamzei Sigma Channels to the same rigorous tests, they would also have difficulty making the grade.