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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.

True Out-of-Sample Test of “Best” Technical Trading Rules

How do the technical trading rules that work best in a past study perform for new data? In the March 2012 version of their paper entitled “Predictability of the Simple Technical Trading Rules: An Out-of-Sample Test”, Jiali Fang, Ben Jacobsen and Yafeng Qin re-test performances of the 26 best technical trading rules from a 20-year old study with new data. This true out-of-sample approach avoids biases arguably endemic in retrospective testing. The selected 26 trading rules are those that perform best as applied to the Dow Jones Industrial Average (DJIA) during 1897 through 1986. These best rules are reasonably representative of rules applied in practice, comprising three groups: variable-holding interval moving average rules; fixed-holding interval moving average rules; and, trading range breakout rules. Analysis assumes long and short positions according to buy and sell signals (not long and cash). Using daily closes for DJIA during January 1987 through March 2011 and during February 1885 through December 1896, and for the S&P 500 Composite Index during January 1987 through March 2011, they find that: Keep Reading

Moving Averages and REIT Indexes

Does timing based on simple moving averages (SMA) work for U.S. Real Estate Investment Trust (REIT) indexes? If so, which moving average is best? In his March 2012 paper entitled “The Market Timing Power of Moving Averages: Evidence from US REIT Indexes”, Paskalis Glabadanidis tests the effectiveness of SMAs for timing ten value-weighted and ten similar equal-weighted U.S. REIT indexes. A monthly close above (below) its SMA signals investment in the REIT index (cash, estimated as the 30-day U.S. Treasury bill yield) the next month. He focuses on a 24-month SMA, but includes robustness tests based on 6-month, 12-month, 36-month, 48-month and 60-month SMAs. He applies baseline one-way trading frictions of 0.5% for entering and exiting a REIT index. Using monthly value-weighted and equal-weighted levels of ten U.S. REIT indexes during 1980 through 2010 (31 years), he finds that: Keep Reading

Pairs Trading and Market Turbulence

Are there market conditions most conducive to stock pairs trading? In their March 2012 paper entitled “Losing Sight of the Trees for the Forest? Pairs Trading and Attention Shifts”, Heiko Jacobs and Martin Weber assess how big-picture turbulence relates to profitability of stock pairs trading, hypothesizing that big-picture distractions draw attention away from specific opportunities. Their measure of big-picture distraction is daily regression-based aggregate unexpected returns for 49 U.S. industry portfolios, ranked (in-sample) into distraction deciles for each year. Their pairs trading approach involves each month: (1) selecting the 100 U.S. common stock pairs (out of 200 million possible) with the least divergence over the past 12 months; (2) over the next six months, entering equal long-short positions in any of these 100 pairs when normalized prices diverge by more than two historical standard deviations; and, (3) exiting pair positions when prices re-converge, or after one month if they do not re-converge. A selected pair may trade several times during its six-month active period. They consider trading with and without a one-day delay after signals. Using daily prices for reasonably large (above median market capitalization) and liquid NYSE/AMEX common stocks during 1960 through 2008, and similar data for eight other major international stock markets from the mid-1990s through 2009, they find that: Keep Reading

Frenetic Trading

How fast must traders move to operate efficiently in the high-frequency arena? In their February 2012 paper entitled “High-Frequency Technical Trading: The Importance of Speed”, Martin Scholtus and Dick van Dijk investigate execution speed sensitivity of technical trading rule performance for three highly liquid exchange-traded funds (ETF). They consider 27,424 variations of five price-based and two volume-based types of trading rules: moving average; filter; support and resistance; channel break-outs; price momentum; on-balance volume average; and, volume momentum. The baseline analysis constructs new signals every 60 seconds. They measure impact of eight execution delays (10, 20, 50, 100, 200, 500 and 1,000 milliseconds) on profitability relative to instantaneous execution. Trading frictions include bid-ask spread and impact of trading, but not transaction fees. They also measure typical levels of market activity over intervals of one day, one hour, one minute and one second. Using  complete order information for SPY, QQQQ  and IWM with millisecond timestamp accuracy during normal trading hours for January-September 2009, they find that: Keep Reading

Enhancing Dollar Cost Averaging?

Dollar cost averaging (DCA) is a very simple and intuitive way to buy more (less) of an asset when its price is low (high), thereby achieving some cost efficiency. Is there a simple and reliable way to enhance DCA? In their December 2011 paper entitled “Building a Better Mousetrap: Enhanced Dollar Cost Averaging”, Lee Dunham and Geoffrey Friesen examine allocation rules that retain attributes of traditional DCA but adjust to new information. Specifically, enhanced DCA (EDCA) rules adjust the amount invested in an asset according to its prior-month return. For example, one EDCA rule adds (subtracts) a fixed increment to (from) the planned monthly investment in an asset if its return for the prior month is negative (positive). Other alternatives adjust the incremental addition or reduction in monthly contribution depending on the value of the lagged monthly return. They employ both simulation and backtesting to measure the effects of EDCA. Using simulations of up to 30 years and monthly return data for six asset indexes and 100 mutual funds spanning 2000 through 2009, they find that: Keep Reading

Combining Realized Volatility and Simple Moving Averages

Does the effectiveness of simple moving average (SMA) crossing signals vary with stock volatility? In the August 2011 update of their paper entitled “A New Anomaly: The Cross-Sectional Profitability of Technical Analysis”, Yufeng Han, Ke Yang and Guofu Zhou investigate the application of SMAs to portfolios of stocks sorted based on realized volatility. Specifically, each year they sort stocks into deciles by volatility (standard deviation of daily returns over the past year). For each decile, they calculate a price index, an SMA for the index and daily returns based on initial equal weighting. When a decile portfolio is above (below) its SMA, they hold the portfolio (30-day Treasury bills), with a one-day delay for switches. They compare the returns for this timing strategy to buy-and-hold by decile. They focus on a 10-day SMA, but also test 20-day, 50-day, 100-day and 200-day SMAs. Using daily returns for a broad sample of U.S. stocks spanning 1963 through 2009, they find that: Keep Reading

Improving Moving Average Rules?

Is there a reliable way to improve the performance of conventional moving average signals? In the October 2011 and November 2011 versions of their papers entitled “An Improved Moving Average Technical Trading Rule” and “An Improved Moving Average Technical Trading Rule II”, Fotis Papailias and Dimitrios Thomakos investigate a modification of the conventional moving average crossover trading strategy that add a dynamic trailing stop (long-only variation) or a dynamic trailing stop-and-reverse (long-short variation). In order to stay long after a moving average buy signal, the modification requires that the asset price must remain at least as high as the entry price. Specifically:

  1. Price crossing above a moving average, or a short-interval moving average crossing above a long-interval moving average, signals initial entry.
  2. After going long, switching to cash or a short position occurs only if the price falls below the reference entry price (ignoring conventional moving average sell signals).
  3. While long, the reference entry price changes when the crossover signals a sell/switch and then a subsequent buy/re-switch.

Entry and exit/switching times for the modified strategy therefore differ over time from those of a conventional moving average crossover strategy. In comparing modified and conventional strategy performance characteristics, they consider: simple, exponential and weighted moving averages; price crossovers of 5, 20, 50, 100 and 200-day moving averages; and, (5,20), (10,20), (20,50), (20,100) and (50,200) pairs of short-interval and long-interval moving average crossovers. They conservatively assume a delay of one trading day in signal implementation. Using daily prices for broad stock indexes, a variety of exchange-traded funds (ETF) and several currency exchange rates as available, they find that: Keep Reading

Refined Short-term Reversal Strategies

Does short-term (one-month) stock return reversal persist? If so, is there a best way to refine and exploit it? In their March 2012 paper entitled “Short-Term Return Reversal: the Long and the Short of It”, Zhi Da, Qianqiu Liu and Ernst Schaumburg decompose the total short-term reversal into an across-industry component (long prior-month loser industries and short prior-month winner industries) and a within- industry component (long prior-month loser and short prior-month winner stocks within each industry). They then further decompose the within-industry return reversal into three components related to: (1) variation in three-factor (market, size, book-to-market) expected stock returns; (2) underreaction/overreaction to within-industry cash flow news (relative to analyst forecasts); and, (3) a residual component attributable to discount rate news/liquidity shocks. Using monthly data for a broad sample of relatively large and liquid stocks accounting for about 75% of U.S. equity market capitalization over the period January 1982 through March 2009, they conclude that: Keep Reading

Use VIX Technical Signals to Trade Stock Indexes?

Can the forward-looking aspect of the S&P 500 Volatility Index (VIX) amplify technical analysis? In their September 2011 paper entitled “Using VIX Data to Enhance Technical Trading Signals”, James Kozyra and Camillo Lento apply nine simple technical trading rules (three each moving average crossovers, filters and trading range breakouts) to VIX to generate daily trading signals for the S&P 500 Index, the NASDAQ index and the Dow Jones Industrial Average. They reason that a relatively high (low) level of VIX indicates strong (weak) future stock index returns, so technical rules that separate daily levels of VIX into high and low regimes should aid trading. They compare results for VIX rule signals to those for signals generated by applying the rules to the indexes themselves. In all 27 cases (nine rules times three indexes), rule implementation assumes going long (short) an index on the day after buy (sell) signals. Estimated trading friction accounts for the bid-ask spread and a broker fee at the time of each trade. Using daily closes for VIX and the three indexes for January 1999 through July 2009, they find that: Keep Reading

First and Last Hours of Trading

Do U.S. stock market returns during the first and last hours of normal trading days reliably indicate what comes next? To investigate, we analyze average SPDR S&P 500 (SPY) returns during 9:30-10:30, 9:30-15:00, 9:30-16:00 and 15:00-16:00 for normal trading days during 2007 (bullish year) and 2008 (bearish year). Using a sample of SPY one-minute prices spanning 2007-2008, we find that: Keep Reading

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