Technically, It Pays to Think Small

In a March 2005 update of his paper entitled “Simple Technical Trading Strategies: Returns, Risk and Size”, Satyajit Chandrashekar investigates the effectiveness of simple moving average technical trading strategies across ten market capitalization size deciles for the period 1963-2002. He finds that:

The author tests returns from a simple trading strategy using crossovers of short and long-term moving averages. A cover and buy signal results when the short term moving average (lengths 1, 2 or 5 days) crosses over a 1% band around the long term moving average (lengths 200, 150 or 50 days). A sell and go short (on uptick) signal results when the short term moving average crosses under the 1% band around the long term moving average. The 1% band reduces trading whiplash.

• The tested technical trading strategy produces average risk-adjusted excess returns of 1.7% per month for small capitalization stocks, including transaction costs.
• In general, the larger the capitalization, the smaller the excess returns from technical trading.
• For large capitalization stocks, the technical trading strategy does not beat a buy-and-hold strategy.
• The technical trading strategy is more profitable in the first half of the 40-year period examined, implying that markets have become more efficient over time.

In summary, a trading strategy based on simple moving averages is most appropriate for small capitalization stocks. More elaborate and complicated technical trading rules might generate larger returns than demonstrated in the study.

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