The Profitability of Simple Technical Trading Rules Applied on Value and Growth Stocks

Transcription

1 Deparmen of Business Sudies Maser Thesis Auhors: Anders Blomgreen Peersen Lennar Boesdal Academic Advisor: Jan Barholdy The Profiabiliy of Simple Technical Trading Rules Applied on Value and Growh Socks Aarhus School of Business Augus 2006

2 Execuive Summary This hesis sudies he efficacy of he mos simple and commonly used echnical rading rules when applied on American growh and value socks. The period under invesigaion goes from 1986 o A famous sudy conduced by Brock, Lakonishok and LeBaron in 1992 showed ha echnical analysis could indeed creae abnormal profi compared o a buy-and-hold sraegy. Laer sudies esed Brock e al s resuls in he subsequen period (from 1986 and onwards) and reached he conclusion ha he echnical rading rules in quesion could no longer ouperform a passive invesmen managemen sraegy. This hesis is inspired by Brock e al s sudy and uses same mehodology. Eigh moving average rading rules are esed on a growh and value porfolio respecively. The earnings-o-price and book-o-marke raios are used o classify he socks as growh or value socks. The shor moving average is he acual price and he long moving average varies in lengh from 10 o 50 days. Furhermore, he rules are esed wih a 1% band. A boosrap procedure is applied in order o increase he reliabiliy of he ess. However, furher invesigaion is added as o increase he pracical relevance. The resuls are esed in an environmen where raders face ransacion coss. This allows ha he implicaions for he Efficien Marke Hypohesis can be discussed. Transacion coss are se o 0.25% per ransacion. The resuls show ha he rading rules are able o idenify periods wih posiive and negaive reurns. For boh porfolios he mean reurn following buy signals is posiive for all rading rules while i is negaive following a sell signal. Furhermore, sell periods are characerized by higher volailiy han buy periods. This is consisen wih he leverage effec. Moreover, i is showed ha he use of simple echnical rading gives a beer reurn compared o a buy-and-hold sraegy also when adjusing for risk before ransacion coss are accouned for. This is valid for all rading rules and for boh porfolios. For he growh porfolio, hree of he eigh rading rules generae a reurn ha is above and saisically significanly differen from he buy-and-hold a he five percen significance level using a wo-ailed es. For he value porfolio five of he rading rules generae a reurn ha is above and saisically significanly differen from he buy-and-hold sraegy.

3 Due o he fac ha he growh porfolio generaes a very poor reurn, he boosrap mehodology and effecs of ransacion coss are only applied o he value porfolio. As i is well known ha sock reurns presen a number of feaures ha violaes he assumpions behind he -es, boosrap simulaions, as applied in BLL, are performed o check wheher he previous resuls are due o hese feaures. This is srongly rejeced for all he four null models esed, even hough feaures such as auocorrelaion, volailiy clusering and he leverage effec are presen in he reurn series. Thus, he resuls are in general consisen wih hose repored by BLL for he DJIA confirming ha simple echnical rading rules have predicabiliy power for value socks. The seemingly superioriy of he echnical rading rules mus however, be seen in he ligh of he fac ha he assumpions made abou he invesmen environmen are no realisic. When ransacion coss are inroduced he rading rules does no generae a reurn ha is saisically significanly differen from he buy-and-hold reurn. This is rue for all rading rules. This implies ha invesors canno be cerain hey will earn an abnormal reurn by using he esed rading rules on value socks. The fac ha a leas some forecasing power is documened, need no o be a violaion of he EMH. The inroducion of ransacion coss causes ha equaliy, beween he reurn generaed by he rading rules and he reurn obained hrough a buy-and-hold sraegy, canno be rejeced. Thus, he weak form efficiency canno be rejeced for value socks

4 1 INTRODUCTION PROBLEM SPECIFICATION LIMITATIONS STRUCTURE...3 PART ONE: THEORETICAL BACKGROUND TECHNICAL ANALYSIS DEFINITION TECHNICAL TRADING RULES Dow Theory Marke Cycle Model Oher Technical Indicaors Volume Money flows Marke breadh Marke imbalance Simple Trading Rules Moving Average Trading Range Breakou Complicaed Paerns Reversal Paerns Coninuaion Paerns RECAPITULATION EFFICIENT MARKET HYPOTHESIS THE ECONOMETRICS BEHIND THE EMH INFORMATION PARADOX LEVELS OF MARKET EFFICIENCY CHALLENGES TO THE EMH Anomalies The Calendar Effecs The Small Firm Effec The Value Premium Puzzle...39

5 Winner s Curse Implicaions of he Anomalies Volailiy Tes Bubble Theory Tes of Raional Bubbles Noise-Trading An Alernaive Noise-Trading Model RECAPITULATION GROWTH AND VALUE STOCKS VALUE STOCKS GROWTH STOCKS VALUE VS. GROWTH STOCKS...54 PART TWO: EMPIRICAL ANALYSIS EARLIER STUDIES OF TECHNICAL ANALYSIS ALEXANDER, FAMA & BLUME, SWEENEY, BROCK, LAKONISHOK & LEBARON, DATA DATA SOURCE PORTFOLIO CONSTRUCTION DATA BIAS Forward-looking Bias Survivorship Bias Delising Bias RETURN AND RISK TECHNICAL TRADING RULES EMPIRICAL RESULTS TRADITIONAL TESTS Growh Porfolio Value Porfolio The Value Premium...77

6 7.2 FURTHER ANALYSIS Properies of Sock Reurns Preliminary Analysis BOOTSTRAPPING The Boosrap Concep The Boosrap Mehodology of BLL Hypohesis Formulaion The Boosrap Procedure Specificaion and Esimaion of Null Models Resampling of Residuals/Sandardized Residuals Creaion of Reurn Series Creaion of Price and Moving Average Series Technical Analysis Calculaion of Mean, Sandard Deviaion and Fracion Boosrap Resuls EFFECTS OF TRANSACTION COSTS IMPLICATIONS OF FINDINGS CONCLUSION LITERATURE...122

7 Lis of Figures Figure 2.1 The Marke Cycle Model Figure 2.2 Confirmaion of reversals of he primary rend in he DJIA and DJTA Figure 2.3 The Ellio Wave Paern Figure 2.4 Simple one moving average Figure 2.5 Simple Two Moving Averages Figure 2.6 Uprend Channel Figure 2.7 The Head and Shoulder paern Figure 6.1 Moving Average Figure 7.1 Descripive Saisics Figure 7.2 Daily Coninuously Compounded Reurn Figure 7.3 Residual Invesigaions

8 Lis of Tables Table 6.1 Technical Trading rules Table 7.1 Resuls for Growh Porfolio Table 7.2 Tradiional Tes Resuls for he Trading Rules for he Growh Porfolio Table 7.3 Resuls for Value Porfolio Table 7.4 Tradiional Tes Resuls for he Trading Rules for he Value Porfolio Table 7.5 Uni Roo Tes for Saionariy Table 7.6 Tes for Linear Dependency Table 7.7 Auocorrelaion and Parial Auocorrelaion Table 7.8 Schwarz Bayesian Informaion Crierion for ARMA Models Table 7.9 Schwarz Bayesian Informaion Crieria for GARCH Models Table 7.10 ARCH LM Tes for AR (1)-GARCH (1,1) Table 7.11 Schwarz Bayesian Informaion Crieria for EGARCH Models Table 7.12 ARCH LM Tes for AR (1)-EGARCH (1,1) Table 7.13 Esimaion resuls Table 7.14 Boosrap Resuls Table 7.15 Toal Transacion Coss in Percenages Table 7.16 Resuls afer Transacion Cos

9 1 Inroducion The efficiency of capial markes is among he mos fundamenal as well as mos dispued docrines in financial heory. Many aemps have been made o define financial marke efficiency and perhaps he mos famous definiion was formulaed by Eugene F. Fama in 1970 called he Efficien Marke Hypohesis (EMH). The cornersone of he hypohesis is ha he price of a securiy always fully reflecs all available informaion. Due o heir pracical relevance and favorable daa condiions, empirical sudies of marke efficiency have been exremely popular among academics. Numerous sudies have been conduced o explore he vas area of capial markes seeking ou for anomalies and paerns of reurn predicabiliy, evaluaing he validiy of various reurn generaing processes and assessing he accuracy and reliabiliy of miscellaneous marke models. As a resul of his exensive research, wo differen camps have emerged: hose who believe in marke efficiency and hose who argue markes are inefficien. Efficiency advocaes rus ha markes enail all informaion available properly. Consequenly, mispricing in enire markes or single asses canno occur and hence, i is impossible o sysemaically earn any abnormal profi. This sance leads hem o acquire a preference for passive porfolio managemen sraegies. In conras, believers of inefficien markes mainain ha securiy prices do no always reflec informaion correcly. Building heir aciviies on hisorical empirical research, predicive models, sudies of human behavior or simply pure belief, hey acively seek mispricing or recursively occurring paerns in order o realize improved reurns. Perhaps he mos used acive rading sraegy is he use of echnical rading rules. A famous sudy conduced by Brock, Lakonishok and LeBaron in 1992 ( BLL henceforh) showed ha simple forms of echnical analysis could indeed creae abnormal profi compared o a buy-and-hold sraegy. Laer sudies, however, esed Brock e al s resuls in he subsequen period (from 1986 and onwards) and reached he conclusion ha he echnical rading rules in quesion could no longer ouperform a passive invesmen managemen sraegy. 1

10 1.1 Problem Specificaion Technical analysis is widely used in pracice, bu he mehod has no gained much suppor in academic circles. In hese circles he heory of marke efficiency is he preferred heory. The purpose of his hesis is o conribue o he ongoing bale beween advocaes of efficien markes and inefficien markes accordingly. Numerous sudies have esed he profiabiliy of echnical rading rules and hrough his quesioned marke efficiency. Many of hese sudies analyze he rading rules on he basis of sock indices such as he Dow-Jones Indusrial Average (DJIA) and he FT-SE 100. No much has been said abou he behavior of echnical rading sraegies across marke segmens based on valuaion parameers. This hesis will add a new perspecive o he discussion by combining echnical analysis wih a wellknown sock marke anomaly: he value premium puzzle. Thus, he cenral quesion is he following: Is i possible o earn a significanly beer reurn han he reurn generaed by a buyand-hold sraegy hrough he use of simple echnical rading rules when applied on growh and value socks respecively? By invesigaing echnical rading rules a hypohesis abou he efficiency of he financial marke in is weak form as defined by Fama (1970) is indirecly examined. If he echnical rading rules prove o be able o generae a saisical and economical significan beer reurn, he EMH can be rejeced. Due o his fac, he heory of efficien markes will also be covered in he hesis. 1.2 Limiaions In he empirical analysis of echnical rading rules only moving average rules will be used. The reason for his is ha i is possible o use hese rules mechanically and hus, hey are easy esable due o he clear signals produced. Oher rading rules such as e.g. he head-and-shoulder paern are based on subjecive beliefs and ideas and canno be defined mechanically. This makes such rules much more complicaed o es on and herefore his will no be done. The classificaion of socks ino he growh or value porfolio is based on wo 2

11 measures: he earnings-o-price (E/P) and book-o-marke (B/M) raio. These wo measures are commonly used when classifying socks as value or growh socks. Oher measures such as cash flow-o-price and growh in sales are also frequenly used. However, i has been found ha he division of socks based on he E/P and B/M raio is sufficien for he purpose of his hesis. The es period is limied o a 19-year period spanning from 1986 o The reason why his period is of ineres for his sudy is ha BLL in heir 1992 sudy show ha a echnical analysis approach can earn a higher reurn han a simple buyand-hold sraegy when esing on he DJIA from 1897 o However, laer sudies (e.g. Sullivan, Timmerman & Whie, 1999) have showed ha from 1986 and onwards he echnical rading rules esed by BLL (1992) have no ouperformed he simple buy-and-hold sraegy. Hence, i is of ineres o es wheher here are invesmen sraegies ha enables echnical analyss o earn abnormal profis in he period following BLL s (1992) es period. 1.3 Srucure The hesis consiss of wo pars. In par one he heoreical background for he hesis is presened and discussed. In he second par he empirical analysis and he resuls hereof are presened. Par one conains he chapers 2-4. Chaper 2 enails a general descripion of wha echnical analysis is. In his chaper he rading rules used in he empirical par will be emphasized. Chaper 3 covers he EMH and discusses his in deail. The hypohesis has always been subjec for grea aendance and he mos imporan aacks on i are presened in a chronological order. In chaper 4 growh and value socks are defined and discussed. The empirical analysis is presened in par wo. This par consiss of he chapers 5 hrough 8. The second par sars ou wih a shor presenaion of earlier imporan sudies of echnical analysis. In chaper 6 he daase is described. The chaper will emphasize he porfolio consrucion and mehods for calculaing risk and reurns. Chaper 7 repors he resuls of he analysis. The chaper is divided ino hree pars. 3

12 Firs, he resuls are esed in a radiional way hrough he use of a -es. Secondly, he boosrap procedure is applied as used in BLL (1992). The saring poin in a boosrap analysis is o find relevan null models o es agains. To find hese null models, ime series heory mus be consuled, and his heory is herefore described in his par of he chaper. In he las par of he chaper he effec of inroducing ransacion coss is analyzed. By examining he resuls on an afer ransacion coss basis i is possible o commen on he implicaions for he EMH. Finally, he implicaions of he resuls are discussed in chaper 8. As round off, he main findings of he hesis will be summarized in chaper 9. 4

13 Par One: Theoreical Background 2 Technical Analysis Many speculaors are used o rade from a fundamenal perspecive. They use economic daa such as P/E raios, cash flows, book value and general business environmen, o deermine wheher a sock or a marke is over- or undervalued. Technical analysis is, on he oher hand, he sudy of hisoric price movemens or paerns o recognize invesmens yielding abnormal profi. Unlike fundamenal analysis no economical heory lies behind echnical analysis and hence no heoreical explanaion can be found as o why i should work. This is also he reason why many heoriss are no fond of echnical analysis and simply do no accep i. However, sudies show ha using simple echnical rading rules, such as Moving Averages and Trading Range Breakou, can give higher reurn han a buy-and-hold sraegy. The sudy of echnical analysis is also of ineres because i is an imporan par of invesmen behavior. Finally, echnical analysis is ineresing in a hisorical view. Today, free and valuable informaion is easy accessible. Unil recenly, here was no Inerne or any oher source where you could easily ge informaion. In he early years of sock rading, informaion was ofen limied o icker ape wih he laes price and volume on a given sock or index. These facs made i very hard, no o say impossible, o conduc fundamenal analysis on socks and invesors and brokers were forced o make use of echnical analysis. This explains why echnical analysis is a much older profession han fundamenal analysis. The following chaper is based on several books on echnical analysis. Since he books are used inerchangeably here will be no references in he ex as such. The books used are: Brown (1999), Kamich (2003), Hirschey & Nofsinger (2005), Murphy (1986), Pring (1998) and Tvede (2002). 5

14 2.1 Definiion Technical analysis can be defined as he sudy of marke acion, primarily hrough he use of chars, for he purpose of forecasing fuure price rends. The echnician uses hree sources o forecas he marke acion namely, price, volume and open ineres. This informaion is per definiion hisorical and readily available for everybody. Technical analysis is based on hree premises: 1. Marke acion discouns everyhing. 2. Prices move in rends. 3. Hisory repeas iself The basic idea in he firs premise is as follows. Technicians, or chariss, believe ha anyhing ha affecs he marke price of a commodiy is conained in he price already. All a echnician need o sudy is herefore he price acion of he securiy. This price acion reflecs a shif in supply and demand where a siuaion wih demand exceeding supply leads o an increase in price and vice versa. Chariss are no concerned wih he reasons for price changes, hey jus reac on hem. Likewise, he acual price of he sock is also of no concern o he chariss, he jus wans o know wheher i is rising or falling. The second premise deals wih he idea of price moving in rends. If one does no agree wih he hough ha marke prices move in rends here is no poin in sudying echnical analysis. The purpose of analyzing chars is of course o idenify rends as early as possible and hen rade in he direcion of he rend. Technical analyss simply believe in he idea of Newon s firs law of moion; a rend in moion is more likely o coninue han o reverse. Of course, rends differ in many ways and chariss normally divide hem up in ime unis. This is also known as The Dow Theory, which will be covered below. A main ene of his heory is, however, ha here are hree levels of marke rends: primary, secondary and eriary. In shor, primary rends are he long-erm rends, secondary rends are inermediae-erm and eriary rends are 6

15 he shor-erm or daily flucuaions. Figure 2.1 The Marke Cycle Model Source: Pring (2002). The las premise deals wih he view ha he key o predic he fuure lies in undersanding he pas. This implies ha he human psychology plays an imporan facor in echnical analysis. Many years of charing have resuled in many rading rules, which are believed o repea hemselves. I is believed ha since hese paerns have performed well in he pas hey will also perform well in he fuure. All in all, he ar of echnical analysis is o idenify rend changes in early sages and say in he posiion you have aken unil here are enough indicaions of a rend reversal. 2.2 Technical Trading Rules The principles behind echnical analysis are he same. I does no maer wheher you focus on shor-erm or long-erm invesmens, follow a conservaive or speculaive sraegy, he basic principles are sill he same. Prices are deermined by changes in mass psychology and psychology is jus as relevan in shor-erm chars as in longer-erm chars. Also, he basic principles of echnical analysis are he same no maer wha invesmen opporuniies you look a, and no maer where you do i. 7

16 Markes are formed by human acions and people end o make he same misakes. Since human naure is more or less consan, hese misakes or emoional swings keep reoccurring which echnical analyss exploi. As menioned earlier, no economical heory lies behind echnical analysis. Hence, here are no limiaions of he number of rading rules you can make use of. You can, more or less, make your own rading rules by sudying he price of a given index or sock why an exhausive descripion of he opic is impossible o give. Below, he mos imporan issues wihin he area of echnical rading are described. Chariss do no only focus on prices when making decisions bu also include several oher indicaors, which will be described in his par Dow Theory Charles Dow, one of he founders of The Wall Sree Journal and is firs edior, developed Dow Theory in he lae 1890s. Dow was he firs o creae a sock marke average, which he published on July 3rd, The firs average consised of only 11 socks of which 9 were railroad companies. In 1897, he original index was spli ino wo indices, a railroad index and an indusrial index wih 20 and 12 socks respecively. In 1928, he indusrial index was increased o 30 socks and a uiliy index was creaed. I was no unil afer Dow s deah, however, ha his heory was formulaed. His successor as edior, William Hamilon, published more han 250 sock-marke predicions using heories proposed by Dow. Dow s echnical basis for sock marke forecass came o be known as Dow Theory and was ariculaed in he book The Sock Marke Baromeer, published in Dow heory is herefore a naural saring poin in he sudy of echnical analysis. This heory can be considered as he granddaddy of he ar of echnical analysis and mos of wha is acceped under he broad heading of echnical analysis oday derives from Dow Theory. Dow Theory ries o idenify long-erm rends in sock marke prices. Six of he mos imporan and basic enes of he heory are: 8

17 1. The Averages Discouns Everyhing. 2. The Marke Has Three Trends. 3. Major Trends Have Three Phases. 4. The Averages Mus Confirm Each Oher. 5. Volume Mus Confirm he Trend. 6. A Trend Is Assumed o Be in Effec Unil I Gives Definie Signals Tha I Has Reversed. Ad 1. This is one of he basic premises of echnical analysis. I simply means ha all he marke paricipans combined possesses he required informaion needed for assessing he value of a sock and his knowledge is discouned in he price movemens of he marke. Ad 2. Maybe he mos imporan principle of Dow Theory is ha he marke has hree rends: primary, secondary and eriary. The definiion of a rend according o Dow was ha an uprend had o have a paern of rising peaks and roughs and a downrend had o have a paern of successively lower peaks and roughs. The major long-erm rend is called he primary rend and lass anywhere from less han one year up o several years. Secondary, or inermediae, rends are a shorerm move ha usually runs conrary o he primary rend. Secondary rends in a bull marke are called marke correcions whereas in a bear marke hey are referred o as bear raps. A marke correcion is a emporary decline in an oherwise increasing marke, while a bear rap is seen when prices emporarily increase followed by a sharp decline in he marke. A secondary rend lass usually from hree weeks o hree monhs. A eriary movemen lass less han hree weeks and is relaively sensiive owards random disurbances and has no or only limied influence on he wo oher rends. Thus, i also has very lile long-erm forecasing value under Dow Theory. Ad 3. The primary rend can be divided ino hree phases. The firs phase is when he iniial revival of confidence is creaed. In his phase he informed invesors recognize ha he marke has finally discouned all bad economic news. The second 9

18 phase is where mos echnical raders begin o paricipae. In his phase prices begin o move rapidly and he economy acually shows signs of improvemen. The las phase is characerized by rampan speculaion. In his las phase newspapers begin o prin bullish sories and economic news is beer han ever. A his poin of ime he informed invesors begin o sell ou of heir socks since hey realize ha he rend is abou o reverse. Anoher reason why he informed invesors begin o sell heir socks is he fac ha no one else seems o be willing o sell and hence hey can charge a higher price. Ad 4. Before a rend can be considered as such, i mus be confirmed by anoher index. In pracice, he DJIA and Dow Jones Transporaion Average (DJTA) mus boh confirm eiher he bull or bear rend. For a bull marke o begin boh averages have o exceed he previous secondary peak and vice versa for a bear marke. If only one of he averages gives he signal conclusions ofen seems o be erroneous. Signals do no have o be given a exacly he same ime bu he closer hey are he beer. Figure 2.2 Confirmaion of reversals of he primary rend in he DJIA and DJTA Source: Hirschey & Nofsinger (2005). In he figure above, hree siuaions are shown. The green line represens he DJIA 10

19 while he gray represens he DJTA. A poin 1 he DJTA fails o confirm he bear rend indicaed by he DJIA and hus he bull marke is inac. A poin 2, however, he end of he bull marke is confirmed. The lower high and lower low on he DJTA confirms he rend reversal. Poin 3 confirms ha he bull marke has resumed. The higher highs and higher lows on boh averages indicae his resumpion. Ad 5. Anoher imporan facor in confirming a rend is o look a volume. In an uprend volume mus expand when prices are rising and drop when prices are falling. In a downrend i is he oher way around. Volume increases as prices fall and shrink as prices increase. In general erms, volume should follow he direcion of he major rend. I should however, be noiced ha his ene is only a secondary indicaor ha confirms he rend. I is no useful for idenifying he rend in he firs place according o Dow Theory. Ad 6. As menioned earlier, echnical analyss believe in he idea of Newon s firs law of moion. The ar is hen o be able o spo he reversal of a rend. This is no as easy as i sounds, bu chariss have some mehods for idenifying hese reversals. Among some of he bes known are suppor and resisance levels, moving averages, rendlines ec. Technical analyss mus be able o disinguish beween a normal secondary correcion in an exising rend and rue reversal of he primary rend. This can be very difficul and users of he heory disagree abou when he acual reversal signal is given Marke Cycle Model The business cycle is a well-known phenomenon in he economy. Economiss believe ha he economy moves in a rhyhmic cycle from boom o recession. Among echnical analyss here is a widespread belief ha sock markes also move in rhyhmic cycles from boom o recession and back o boom again or, in oher words, hey believe ha here is a endency for prices o roae from marke peak o marke rough in a rhyhmic cycle. Some of he facors ha cause his cyclical movemen are he underlying poliical and economic forces and crowd behavior among humans. I can ake monhs or even years for crowd behavior o rise o he level of irraional exuberance, decline o desponden pessimism and back o irraional exuberance 11

20 again. Some of he famous episodes of irraional exuberance in he U.S. occurred in he lae 60 s wih echnology socks, lae 80 s wih energy socks and finally in he lae 90 s wih echnology socks again. The corresponding lows occurred in 1974, 1982 and 1990 when invesors where unusually pessimisic. One of he bes-known marke cycle models is The Ellio Wave Paern, afer Ralph Nelson Ellio. He believed ha crowd behavior, rends and reversals occur in recognizable paerns. The basic principle of he Ellio Wave Theory is ha sock prices are governed by he Fibonacci numbers (1, 2, 3, 5, 8, 13, 21, 34, 55.) and he upside marke moves in five waves and hree on he downside. Wihin hese waves here can, however, be minor waves and hese also show he same paern as he major wave wih five waves on he upside and hree on he downside. Figure 2.3 The Ellio Wave Paern Source: Own creaion wih inspiraion from Murphy (1986). As i was he case in Dow Theory, he waves can be divided in accordance wih heir size. The major wave decides he major or primary rend of he marke and he minor waves he minor rend. As can be seen in figure 2.3, peak 1 is a par of he major rend whereas he firs rough, marked number 2, is only correcive and herefore only a secondary rend Oher Technical Indicaors While price is he mos used signal for echnical analyss oher indicaors are also used. Some of hese indicaors are used for confirming he signal generaed by he price, bu hey can also be used as a primary signal. 12

21 Volume As described in secion 2.2.1, volume is ofen used as a confirmaion of he rend. Volume has, however, he poenial o provide useful informaion. When invesors are uncerain of he fuure hey normally do nohing. This means ha when volume decreases a reversal can be underway. Therefore, volume can give indicaions of he fuure direcion of prices by measuring he level of confidence among buyers and sellers. Mos of he ime volume is, however, used as a secondary indicaor in connecion wih price movemens as described above Money flows Anoher way of measuring convicion among buyers and sellers is o look a he money flows. Money flow is he relaive buying and selling pressure on sock prices and is measured on a daily basis. Technical analyss ry o figure ou wha he smar money is doing. Invesors alk abou upick and downick rades where an upick rade is a rade a a higher price han he previous day and vice versa. To ge he money flow of a sock or a porfolio, he share price is muliplied by he number of shares raded. The ne gain or ne loss is hen he money flow. The inerpreaion of he money flow is quie logical. A buyer requires a seller bu hey have differen opinions of he price. I is, however, he supply and demand ha deermines he marke price. If a larger number of socks changes hands in an upick rade buyers are more willing o buy a he price suggesed by sellers han sellers are willing o dump prices. The buy invesors can hen be classified as more-aggressive invesors and hey are expeced o carry he price rend over ime. Hence, posiive money flow figures are a sign of a bullish marke. Finally, i should be menioned ha money flow daa are repored for boh insiuional rades and individual rades. Block rades, which is rades ha consiss of or more shares, reflecs insiuional invesors while nonblock rades indicaes individual socks and various major sock indices Marke breadh In a bull marke i is no necessarily all socks ha are rising in price. Neiher socks nor markes rise or fall in sraigh lines. Some flucuaions will always occur and 13

22 some socks will go agains he major rend. Idenifying he major rend can be done by calculaing he marke breadh. The marke breadh measures how many socks are increasing in price relaive o he number of socks decreasing in price. One of he mos used ways o deermine he marke breadh is probably he advance/decline raio. Technical analyss consider his raio as a good indicaion of he overall direcion of he marke and can be deermined by dividing he number of socks rising in price by he number of socks declining in price. If he raio is above 1 he marke is considered bullish and if he raio is below 1 i is bearish. Anoher way o measure he breadh of he marke is o use he advance/decline line. This mehod is very similar o he advance/decline raio, bu differs in he way ha i uses he ongoing sum of he difference beween rising and declining socks. For he breadh o be healhy he line has o rise indicaing ha here are more posiive price movemens han negaive. Normally, he overall marke and he advance/decline line moves ogeher bu a imes a so-called divergence emerges. This occurs when he overall marke coninues o move higher while he advance/decline line drops. Technicians see his as a warning of a pending reversal of he rend Marke imbalance More han 30 years ago, Sherman McClellan and his wife invened he McClellan Oscillaor. This indicaor of he marke rend, smooh he advance/decline daa by using moving averages 1. The oscillaor graphs he difference beween he 19-day moving average and he 39-day average of ne number of advancing socks. A posiive McClellan Oscillaor indicaes a bullish marke is in progress. If he oscillaor however, ges oo high, he marke is considered as overbough by echnicians. When he number ges oo low he marke is hough of as oversold and he marke may be a is boom. The Arms Index, also known as he rading index (TRIN), is probably an even more used indicaor of marke imbalance. To derive TRIN, he raio of rising socks o declining socks is divided by he raio of he volume of advancing socks o he volume of declining socks. If TRIN is below one he marke is considered bullish and above one bearish. Generally, echnicians believe ha if TRIN is below 0.65 he 14 1 See secion for a deailed descripion of moving averages.

23 marke is very bullish and if i is above 1.35 i is very bearish. For deecing marke imbalances echnicians believe ha he higher he smoohed or averaged TRIN reading is he more oversold i is, and he lower he reading he more overbough he sock or he marke is. Hence, exreme oversold readings indicae a poenial marke boom and exreme overbough readings is inerpreed as poenial marke peaks Simple Trading Rules In he following par, wo simple rading rules will be described. The moving average rading rules, ha will be empirically esed, will be emphasized Moving Average Probably he mos versaile and used rading rule is he moving average rading rule. The rule has been used for a leas 50 years and belongs o caegory of indicaors called rend-following indicaors. These indicaors are mean o smooh he price paern of indices or socks making i easier o idenify beginnings and end of rends and idenify he underlying rend. The reason why moving average is so widely used may be because buy and sell signals can easily be compued ino a compuer. Char analysis is largely subjecive and difficul o es. Technicians may disagree wheher a price paern is a head-and-shoulder paern or a flag paern while moving averages is a mahemaical calculaed paern leaving no issues open for debae. As he erm implies, moving average is a echnique where he daa of a cerain sock or an index is averaged over a ime period. There are no specific demands o he lengh of he ime period, bu i has o fi he rading issue. Also, differen prices can be used. Normally, however, he closing price is used, bu here is no rule ha says you canno use oher prices such as highs, lows or maybe even a combinaion of more prices Simple Moving Average The mos commonly ype of average used is he simple moving average. The calculaion of his average is very simple. If a 20-day average is needed, he price of each day for he las 20 days is added and hen divided by 20. To make i a moving average, he oldes observaion is subraced and a new is added. To find ou wha 15

24 lengh he average should have, logic sense mus be applied. If you need weekly daa a 4-week daa may seem reasonable. If monhly daa is needed a 12-monh moving average is more useful. The simple moving average has, however, wo major drawbacks. The firs is he fac ha i only covers he period under observaion. I oally excludes earlier daa, which migh conain useful informaion. The second criicism is ha each observaion is given equal weigh. The oldes observaion is in oher words regarded jus as imporan as he newes. Some analyss argue ha more recen observaions should be given more weigh in he average. This drawback makes perfec logical sense especially for moving averages wih longer ime span such as 50-day and 200-day moving averages. To correc for his, he linearly weighed moving average and exponenial moving average have been creaed The Linearly Weighed Moving Average The easies way o correc for he second of he above-menioned problem is o use he linear weighed average. By using his average more recen observaions are given more weigh han old ones. If a 5 day moving average is used, he observaion on he fifh day is muliplied by five; he observaion on he fourh day is muliplied by four ec. The oal is added up and divided by he sum of he mulipliers. In his lile example, he sum of he observaions is divided by 15 ( =15). The linear weighed moving average mehod does, however, no help wih he so-called drop-off effec. To correc for boh problems, analyss mus urn o he exponenially smoohed moving average The Exponenial Moving Average The exponenial moving average is also a weighed average assigning more weigh o recen observaions. The oldes price observaions are never removed from he daa bu he furher back hey are, he less weigh hey are given in he calculaions. The formula for he exponenial moving average is: (2-1) EMA = α price( 1 α) EMA 1 2 where α =. N

25 Advocaes of he exponenial moving average argue ha his kind of moving average is relaively easy o mainain by hand day by day. The only daa needed is he previous day s exponenial moving average daa and oday s closing daa One Moving Average The moving average is jus a line on a piece of paper or a compuer screen and is no by iself a signal ha can be used for making buy or sell decisions. To make signals ou of he average, analyss benchmark eiher one or more agains he acual price or each oher. The simples way o generae a signal is by using one moving average and compare i o he acual price. The idea behind his is ha in an uprend, he moving average ends o lag he price acion and rails below he prices. If he acual price moves above he moving average a buy signal is generaed and conversely, if he price moves below he average a sell signal is generaed. Figure 2.4 Simple one moving average Source: hp://finance.yahoo.com, April As can be seen in he figure several buy and sell signals for he XM Saellie Radio sock are generaed. The firs signal is a sell signal, which occurs in lae April Around July 20 h a buy signal is generaed as he price of he sock breaks he moving average line from below. An unforunae characerisic of he one moving average echnique is ha in a rading-range marke i is a money-losing indicaor. If you reac on all signals, he ransacion coss will ea up he gains. Wih his rading rule, you are always in he marke, eiher shor or long. The problem is illusraed a he end of July and beginning of Augus. Here he price crosses he moving average line four imes. The hree firs crossovers are false signals while he las one is a 17

26 rue signal. Even hough he shorer averages generae more false signals hey also have he advanage of giving rend signals earlier in he move. Hence, analyss mus make a rade-off wheher o reac early in he rend or save some ransacion coss. There are various ways of dealing wih he problem of oo many signals. The easies is o adjus he lengh of he moving average. By doing ha, only significan price violaions are given. This gives laer buy and sell signals bu i also gives rise o anoher problem. Wih a shor moving average i is possible o reac early in he rend whereas a long moving average resul in fewer so-called whipsaws bu he signals are lae. Anoher way o correc he problem is o add a filer on he moving average. There are numerous filers ha can be used helping analyss o reac only on real buy signals. Some common filers are: Closing price: The price mus close above or below he moving average line o be a valid crossover. Some analyss even require ha he enire day s price range clear he average. Time filers: Because mos false signals correc hemselves relaively quickly, some raders require he crossover o remain in force for a cerain ime period. The ime period can las from a couple of days o a week. Percenage bands: This is a very popular filer and will also be used in he empirical analysis. For a signal o be generaed he price of he sock mus cross he moving average by a cerain percenage of he price of he moving average. The percenage band creaes a buffer zone around he moving average line. As long as he price lies wihin his buffer zone, no acion is aken. Acion is firs aken when he price crosses eiher he upper or lower percenage band. The quesion how large he buffer zone should be is again a rade-off. If i is decided o use small percenages he risk of rading on false signals is greaer, bu he chance of geing early in on a rend is also greaer. In he empirical analysis he band will be a 1 percen band. High-low band: Insead of using closing price as indicaor he high and low price of each day is can be used. This resul in wo moving averages: one 18

27 for he highes price and one for he lowes. A buy signal is generaed when he closing price lies above he line for he highes average. Similarly, a sell signal is given when he closing price is below he lower average Two Moving Averages Technicians also have oher possibiliies for making beer decisions besides he use of filers. An effecive and common mehod is o use wo moving averages simulaneously. The averages are of differen lenghs wih he shores of hem used insead of he acual price and he longes o idenify he underlying rend. There are numerous combinaions of averages ha can be used, bu some very common combinaions are he 5- and 20-day averages and 10- and 40-day averages. For a signal o be given he shorer average mus cross he longer average. If he shorer moving average crosses from below a buy signal is given and if i crosses from above a sell signal is given. The use of wo moving averages lags he signal a lile bi, bu he advanage is ha i produces fewer whipsaws han by he use of only one moving average. I should be noiced ha i is he simple moving average ha lies behind he mehod described above. Anoher way o make use of a wo moving average mehod is o creae an oscillaor. The oscillaor is he mahemaical difference beween he shor and long moving average. I measures wheher a marke is overbough or oversold. When a securiy lies oo far above he longer moving average i is overbough and echnicians believe ha he price will fall. Anoher way of inerpreing he oscillaor is o look a crossovers on he zero line. If i crosses from below, a buy signal is given and vice versa. 19

28 Figure 2.5 Simple Two Moving Averages Source: hp://finance.yahoo.com, April In figure 2.5 some of he problems from he one moving average mehod are correced. The issue wih he whipsaws around augus 2004 is correced since he shorer moving average does no cross he longer moving average and hence, no false signals are given. Below he price curves, he oscillaor is shown Three Moving Averages To make even fewer misakes, echnicians make use of hree moving averages. The analogy is, if wo averages resuled in fewer false signals han one, hree mus resul in fewer han wo. Technicians choose he lengh of he hree moving averages in differen ways. Probably he mos used way is o use cycle lengh as a deciding facor. The firs moving average is a 5-day moving average represening a week. The second is a 21-day average represening a monh and finally a 63-day moving average for a quarer. Anoher way is o use harmonic numbers. If his sraegy is used, you simply muliply he nex longer average wih a facor of wo. This means ha if he firs moving average is a 10-day average he nex moving average will be a 20-day moving average and so forh. Lasly, some also make use of he Fibonacci numbers described earlier. A popular hree moving average sysem based on hese numbers is a 5-, 13- and 34-day moving average. The rading rules wih hree moving averages are similar o hose under one and wo moving averages. The general principle is ha he longer moving average mus cross he shorer o generae a signal. A sell signal is generaed when he e.g. 5-day 20

29 average crosses he 21- day average and he 21-day average crosses he 63-day average from above. Wih hree averages here is an in-beween. The period from he fases moving average crosses he medium unil he medium average crosses he slowes moving average is a period wih no clear signals. This is one of he imporan differences beween using a one or wo moving average mehod and a hree moving average mehod. Wih one and wo moving average mehods you are always in he marke. These mehods ell you only wheher o ake a shor or a long posiion. Wih hree moving averages here is a period in-beween where you are ou of he marke. The firs sign of a reversal of a rend is ha he fases moving average crosses he medium average. As soon as his happens he posiion is liquidaed and a posiion ou of he marke is aken. When he medium average hen crosses he longes average a new posiion is aken again. Of course here is a cach by using hree moving averages. The mehod resuls in fewer whipsaws bu a he same ime he firs par of he rend is missed. The more averages aken ino consideraion he less risk is aken and hence, he lower reurn you will ge Trading Range Breakou As described earlier, echnical analysis builds on he belief ha price moves in rends. A rend can move in hree direcions, sideways, upwards and downwards. To be able o use hese rends and easier reac on hem, echnicians ofen draw rend lines. Trend lines can be drawn from eiher he lows in an uprend and highs in a downrend or hrough some key closes. The ime issue is very imporan when using rend lines. If you have a very shor ime horizon, a 10-year rend line is of very lile use. Similar a wo-week rend line will rigger oo many signals for a rader wih a five-year ime horizon. The echnique of drawing rend lines is subjecive. This means ha no formula can be used o help you draw he line; you mus simply draw wha you hink you see. The fac ha i is a subjecive echnique makes i hard o use for buy and sell signals. If he price crosses he rend line from eiher below or above i should be a signal. However, he line is drawn from your own believes and i is very hard o say wheher 21

30 he line has been drawn correcly. Maybe he line ough o have been drawn more seep or flaer. To help making beer decisions some analyss use bands around he line. Typically hese bands are 1% or 3% bands. The idea is, in case of a 1% band, ha he securiy mus rade more han 1% above or below he line before acion is aken. If he band approach is aken he signals ha are generaed mus be used as mechanical signals; if he price reaches he 1% or 3% level acion is required wihou any exra hesiaion. Anoher way o use rend lines is o draw wha is referred o as channels. Basically, wo rend lines are drawn; one up or downrend line and a reurn line also called channel line. To be able o draw a channel in an uprend, wo booms wih an inervening high followed by anoher high a a level higher han he inervening high is needed. In a channel four possible kind of signals are generaed, wo in uprend and wo in a downrend. If he price in an uprend does no reach he uprend line analyss believe ha he price acceleraes and a seeper rend has begun. If he price, however, fails o reach he reurn line i may be a signal of a reversal of he rend. The signals in a downrend are of course similar o hose in an uprend jus he opposie way. Figure 2.6 Uprend Channel Source: Own creaion wih inspiraion from Murphy (1998). The idea of a channel is illusraed in he figure above. As can be seen here are wo roughs and wo peaks wih he laer of hem above he prior. This makes i possible o draw he channel, which in his illusraion is an uprend channel. A signal is 22

31 generaed where he las peak fails o reach he reurn line. Hereafer, he price crosses he uprend line and analyss believe ha a rend reversal has occurred Suppor and Resisance When he price of a sock keeps bouncing back and forh beween wo price levels and no clear rend can be observed, analyss make use of suppor and resisance levels. The suppor level refers o he roughs of a price curve. Afer a cerain period of declining prices, he price will hi he suppor level. A ha poin he buying pressure is sufficienly srong o overcome he selling pressure and he price will begin o rise again. The previous rough normally defines he suppor level. Conversely, afer a period wih rising prices, he resisance level is reached. A his level selling pressure overcomes buying pressure and prices will sar o fall again. As wih suppor level a previous peak defines he resisance level. In he range beween suppor and resisance here is so o say a war beween buyers and sellers. A one poin, however, one of he sides will win and he suppor or resisance level is broken. A his poin he rend reveals iself. If he rend is an uprend he price will cross he resisance level while in a downrend he suppor level is crossed. When one of he lines is crossed he roles of hem are reversed. This means ha if he suppor level is crossed from above i becomes he new resisance level and if he original resisance level is broken i becomes he new suppor level. The reason for his is ha invesors have he price in mind. Invesors wan o ge ou of losing rades a break-even. Similarly, raders seek o increase winning posiions by buying more socks a or near he suppor level. Anoher psychological aspec of suppor and resisance levels is he role of round numbers as suppor and resisance. Round numbers has a endency o sop advances or declines. Invesors end o see round numbers such as 50, 100, ec. as price objecives and ac accordingly. Hence, round numbers ofen ac as psychological suppor or resisance levels Complicaed Paerns Price paerns consiss of wo caegories, namely reversal and coninuaion paerns. Reversal paerns generae signals of reversing rends whereas coninuaion paerns 23

32 are only a shor pause of a rend, maybe o correc for overbough or oversold condiions. Afer he pause he exising rend will be resumed. In he following some reversal paerns will be described followed by a descripion of a few coninuaion paerns. These paerns all belong o wha can be classified as complicaed rading rules, which refers o he fac ha hey build on subjecive opinions and are impossible o calculae mahemaically Reversal Paerns As he name indicaes he following paerns indicae an imporan change in he exising rend. Mos changes in rend are no abrup affairs bu evolve over a longer period. The ar is hen o idenify hese rend changes as early as possible in order o profi as much as possible Head and Shoulders The mos famous of he reversal paerns is wihou doub he head-and-shoulders paern. In is simples form he paern consiss of hree peaks, when looking a paern wih ops. The middle of he hree, also called he head, is he highes and is surrounded by wo lower peaks. The wo lower peaks are known as he lef and righ shoulder. I is possible o draw a rend line in he paern as well. The line joins he roughs immediaely o he lef and righ of he head and is called he neckline. In an uprend he neckline generally has a sligh upward slope bu can also be horizonal and someimes even downward sloping. As wih all rend lines, he signal is generaed when here is a crossover of he line, in he case of a head-and-shoulder paern, he neckline. The breaking of he neckline is a signal ha he series of rising peaks and roughs has reversed and a series of declining peaks and roughs is now in force. The paern is shown in figure