Technical Trading

Does technical trading work, or not? Rationalists dismiss it; behavioralists investigate it. Is there any verdict? These blog entries relate to technical trading.

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Bollinger Bands: Buy Low and Sell High?

Are Bollinger Bands useful for specifying low and high levels of the overall U.S. stock market? In other words, can an investor beat a buy-and-hold strategy by systematically buying (selling) when the market crosses below (above) the lower (upper) Bollinger Band? To check, we examine the historical behavior of of Bollinger Bands around the 21-trading day (one month) simple moving average of S&P 500 SPDR (SPY) as a tradable proxy for the U.S. stock market. Using daily dividend-adjusted closes of SPY and contemporaneous yields for 13-week Treasury bills (T-bill) from the end of January 1993 (SPY inception) through February 2015, we find that… Keep Reading

Using RSI(2) to Trade Leveraged ETFs

A subscriber asked about the effectiveness of applying a two-period Relative Strength Index, RSI(2), to leveraged exchange-traded funds (ETF), suggesting two pairs of trade entry (oversold) and exit (overbought) settings:

  1. Buy when RSI(2) falls below 10 and sell when it subsequently rises over 90 (10-90).
  2. More conservatively, buy when RSI(2) falls below 5 and exit when it subsequently rises over 70 (5-70).

To investigate, we run simple tests on ProShares Ultra S&P 500 (SSO) with RSI(2) calculations based on the RSI template from StockCharts. Using daily dividend-adjusted SSO opens and closes during July 2006 (the first full month SSO is available) through January 2015, we find that: Keep Reading

When, Where and Why Stock Pairs Trading Works

Is stock pairs trading particularly successful under predictable conditions? In their December 2014 paper entitled “On the Determinants of Pairs Trading Profitability”, Heiko Jacobs and Martin Weber present a large-scale analysis of pairs trading, evaluating the effects on profitability of the type of news driving pair divergence, the level of available investor attention and obstacle to exploitation (limits of arbitrage). Their pairs trading approach (see the first chart below as an example) employs daily stock price data to:

  1. Calculate each month normalized total return trajectories of stocks over the past 12 months.
  2. Measure differences in trajectories for all possible stock pairs.
  3. Select the 100 pairs with minimum differences and re-normalize their prices.
  4. Whenever over the next six months a pair diverges by more than two standard deviations (per the above 12-month interval), buy the underpriced stock and sell the overpriced stock after a one-day delay.
  5. Close the positions upon price convergence within the next month with a one-day delay. If prices do not converge, close the positions after one month. A pair may trade several times during the six-month trading period.

Using stock return data from 34 countries during 2000 through 2013 (excluding small and illiquid firms) and a sample of U.S. stocks with greater than median capitalizations during 1962 through 2008 with contemporaneous news, investor attention and cost of trading proxies, they find that: Keep Reading

Upside-Downside Participation Ratio Difference as an Alpha Proxy

Is the difference between upside and downside asset participation ratios relative to a benchmark a useful metric for evaluating asset investment performance? In his June 2014 paper entitled “On the Holy Grail of ‘Upside Participation and Downside Protection'”, Edward Qian defines and investigates the performance implications of the Participation Ratio Difference (PRD) as a measure of combined upside participation and downside protection. He defines the upside (downside) participation ratio of an asset as the ratio of expected excess return for the asset to the expected excess return of its benchmark when benchmark returns are positive (negative). “Excess” means in excess of the return on cash (such that cash has zero participation rates). He defines PRD as the simple difference between positive participation ratio (P+) and negative participation ratio (P-). He then investigates the relationship between asset PRDs and one-factor (market) alphas. He then checks PRDs for the S&P 500 sectors (with the S&P 500 Index as the benchmark) and PRDs for Russell style indexes (with the Russell 3000 Index as the benchmark). Using monthly returns of the S&P 500 index and its ten sectors during October 1989 through April 2014 and monthly returns of Russell broad and value-growth style indexes during January 1979 through April 2014, he finds that: Keep Reading

Comprehensive, Long-term Test of Technical Currency Trading

Does quantitative technical analysis work reliably in currency trading? If so, where does it work best? In their May 2013 paper entitled “Forty Years, Thirty Currencies and 21,000 Trading Rules: A Large-Scale, Data-Snooping Robust Analysis of Technical Trading in the Foreign Exchange Market”, Po-Hsuan Hsu and Mark Taylor test the effectiveness of a broad set of quantitative technical trading rules as applied to exchange rates of 30 currencies with the U.S. dollar over extended periods. They consider 21,195 distinct technical trading rules: 2,835 filter rules; 12,870 moving average rules; 1,890 support-resistance signals; 3,000 channel breakout rules; and, 600 oscillator rules. They employ a test methodology designed to account for data snooping in identifying reliably profitable trading rules. They also test whether technical trading effectiveness weakens over time. In testing robustness to trading frictions, they assume a fixed one-way trading cost of 0.025%. Using daily U.S. dollar exchange rates for nine developed market currencies and 21 emerging market currencies during January 1971 through July 2011, they find that:

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Where Technical Trading Works

In which country stock markets is technical analysis likely to work best? In the October 2014 version of her paper entitled “Technical Analysis: A Cross-Country Analysis”, Jiali Fang investigates three potential cross-country determinants of technical trading profitability:

  1. An individualism index, measuring the degree to which individuals integrate via cultural groups.
  2. Market development and integrity metrics, including stock market size, stock market age, transaction costs and measures of investor protection, anti-director rights, ownership concentration and insider trading.
  3. Information uncertainty metrics, including aggregate market turnover, volatility of cash flow growth rate and book-to-market ratio.

She considers 26 previously studied trading rules employing only past prices, classified as: variable moving average (VMA) rules, fixed-length moving average (FMA) rules and trading range break-out (TRB) rules. VMA rules are long (short) an index when a short-term moving average is above (below) a long-term moving average. FMA rules are similar to VMA rules, but hold a newly signaled position a fixed interval of 10 days. TRB rules generate buy (sell) signals when price rises above (falls below) the resistance (support) defined by prices over a specified past interval. Tests include both regressions and model strategies that are long (short) the market index as signaled and invest in the risk-free asset when there is no signal. Using cultural metrics, daily stock market index data and economic/financial variables for 50 countries during March 1994 through March 2014, she finds that: Keep Reading

Intrinsic Momentum or SMA for Avoiding Crashes?

A subscriber suggested comparing intrinsic momentum (also called absolute momentum and time series momentum) to simple moving average (SMA) as alternative signals for equity market entry and exit. To investigate across a wide variety of economic and market conditions, we measure the long run performances of entry and exit signals from intrinsic momentum over past intervals of one to 12 months (designated MR1 through MR12).  Based on conclusions in “Is There a Best SMA Calculation Interval for Long-term Crossing Signals?”, we compare these performances with that the 10-month SMA (designated SMA10). We consider two cases for intrinsic momentum signals: (1) in stocks (cash) when past return is positive (negative); and, (2) in stocks (cash) when average monthly past return is above (below) the average monthly risk-free rate over the same measurement interval. Using monthly data for the 13-week Treasury bill (T-bill) yield as the risk-free rate and the Dow Jones Industrial Average (DJIA) as a proxy for the U.S. stock market during January 1934 through September 2014 (over 80 years), we find that: Keep Reading

Martin Zweig’s Four Percent Model

A reader inquired about the validity of Martin Zweig’s Four Percent Model, which states (from pages 93-94 of the 1994 version of Martin Zweig’s Winning on Wall Street):

“The Four Percent Model for the stock market works as follows. First, It uses the Value Line Composite Index…an unweighted price index of approximately seventeen hundred stocks… All you need to construct this model is the weekly close of the Value Line Composite. You can ignore the daily numbers if you wish… This trend-following model gives a buy signal when the weekly Value Line Index rallies 4% or more from any weekly close. It then gives a sell signal when the weekly close of the Value Line Composite drops by 4% or more from any weekly peak. …That’s all there is to it. …The model is designed to force you to stay with the market trend.”

We execute this description as follows (after identifying the first signal):

  • After a buy signal, generate the next sell signal upon a 4% or greater decline from a subsequent high water mark (including the buy signal level).
  • After a sell signal, generate the next buy signal upon a 4% or greater advance from a subsequent low water mark (including the sell signal level).

We test the usefulness of the signals on the following exchange-traded funds (ETF) over their entire available histories: SPDR S&P 500 (SPY), PowerShares QQQ (QQQ), iShares Russell 2000 Index (IWM) and Guggenheim S&P 500 Equal Weight (RSP). Using weekly closes of the Value Line Geometric Index and the dividend-adjusted weekly opens of the selected ETFs from their respective inceptions through September 2014, we find that:

Keep Reading

Simple Tests of Sy Harding’s Seasonal Timing Strategy

Several readers have inquired about the performance of Sy Harding’s Street Smart Report Online, which includes the Seasonal Timing Strategy. This strategy combines “the market’s best average calendar entry [October 16] and exit [April 20] days with a technical indicator, the Moving Average Convergence Divergence (MACD).” According to Street Smart Report Online, applying this strategy to a Dow Jones Industrial Average (DJIA) index fund generated a cumulative return of 213% during 1999 through 2012, compared to 93% for the DJIA itself. As a robustness test, we apply this strategy to the SPDR S&P 500 (SPY) exchange-traded fund since its inception. Using daily dividend-adjusted closing prices for SPY and daily 13-week Treasury bill (T-bill) yields during 1/29/93 (inception of SPY) through 9/30/14, we find that: Keep Reading

Comparing Ivy 5 Allocation Strategy Variations

A subscriber requested comparison of four variations of an “Ivy 5″ asset class allocation strategy, as follows:

  1. Ivy 5 EW: Assign equal weight (EW), meaning 20%, to each of the five positions and rebalance annually.
  2. Ivy 5 EW + SMA10: Same as Ivy 5 EW, but take to cash any position for which the asset is below its 10-month simple moving average (SMA10).
  3. Ivy 5 Volatility Cap: Allocate to each position a percentage up to 20% such that the position has an expected annualized volatility of no more than 10% based on daily volatility over the past month, recalculated monthly. If under 20%, allocate the balance of the position to cash.
  4. Ivy 5 Volatility Cap + SMA10: Same as Ivy 5 Volatility Cap, but take completely to cash any position for which the asset is below its SMA10.

The subscriber proposed the following five asset class proxies for testing:

iShares 7-10 Year Treasury Bond (IEF)
SPDR S&P 500 (SPY)
SPDR Dow Jones REIT (RWR)
iShares MSCI EAFE Index (EFA)
PowerShares DB Commodity Index Tracking (DBC)

The DBC series in combination with the SMA10 rule are limiting with respect to sample start date and the first return calculations. Using daily and monthly dividend-adjusted closing prices for the five asset class proxies and the yield on 13-week U.S. Treasury bills (T-bills) as a proxy for return on cash during February 2006 through August 2014 (103 months), we find that: Keep Reading

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