Blog - Investing Notes
April 11, 2005 –
Technical Trading Thoroughly Tested
In their March 2005 paper entitled
"Re-Examining the Profitability of
Technical Analysis with White’s Reality Check and Hansen’s SPA Test", Po-Hsuan Hsu and
Chung-Ming Kuan examine the profitability of a very large universe of technical trading rules and
strategies against the Dow Jones
Industrial Average (DJIA), S&P
500, NASDAQ Composite
and Russell 2000 stock indices.
Their approach and findings, using data from 1989-2002, are as follows:
The authors consider a universe of 39,832 simple trading rules, simple contrarian
rules and investor strategies, defined as follows:
- 18,326 simple rules in 12 classes: Filter Rules (FR),
Moving Averages (MA), Support and Resistance (SR), Channel Break-Outs
(CB), On Balance Volume Averages (OBV), Momentum Strategies in Price
(MSP), Momentum Strategies in Volume (MSV), Head and Shoulders,
Triangle, Rectangle, Double Tops and Bottoms and Broadening Tops and Bottoms.
- 18,326 simple contrarian rules that are the opposite positions
of the preceding simple rules.
- 3,180 investor strategies based on the information generated
from many simple rules in three classes: learning strategies (LS -
following the best-performing rule within a rule class), voting strategies
(across the trading rules in a rule class) and position changeable strategies
(allowing weighted positions).
In applying all these rules and strategies against the four major stock indices
identified above, the authors conclude that:
- The best simple rules are:
- For the DJIA, a momentum strategy in volume rule (NOT
SIGNIFICANT)
- For the S&P 500, a contrarian on balance volume rule (NOT
SIGNIFICANT)
- For the NASDAQ, a two-day moving average rule (HIGHLY
SIGNIFICANT)
- For the Russell 2000, a two-day moving average rule (HIGHLY
SIGNIFICANT)
- Most profitable rules and strategies for the NASDAQ and Russell
2000 are constructed from filter rules and moving averages rules. (See the table
below from the paper.)
- No contrarian rule is significantly profitable.
- All of the profitable investor strategies are learning
strategies, and there are many more profitable investor strategies than there
are profitable simple rules. In fact, there are profitable investor strategies that
are based on non-profitable simple rules. Technical investors are apparently able to
extract and enhance information from simple rules.
- After accounting for transaction costs, the best rules and strategies
generally beat a buy-and-hold strategy for both in-sample and out-of-sample periods.

In summary, technical analysis can be significantly profitable
when applied to relatively immature stock indices (NASDAQ Composite and Russell 2000) but not
when applied to mature stock indices (DJIA and S&P 500). Speed of information dissemination
and liquidity for stocks within an index may be critical to the success of technical analysis
on that index.
See Blog
Synthesis: Some Trading Indicators for analyses of the usefulness
of other technical indicators.