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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.

Pairs Trading Net Profitability

Is pairs trading (buying the loser and selling the winner of close-substitute stocks that have diverged unusually in price) profitable after accounting for reasonable trading frictions? In the November 2010 version of their paper entitled “Are Pairs Trading Profits Robust to Trading Costs?”, Binh Do and Robert Faff examine the impact of trading friction (commissions, market impact and short selling fees) on pairs trading profitability. Their baseline pairs trading strategy consists of: (1) finding a partner for each stock that minimizes normalized price spread during a 12-month formation period; (2) screening the best pairs based on lowest tracking error; (3) within six months after pairs identification, opening long/short positions in the underpriced/overpriced members of the best pairs with normalized price divergences of at least two standard deviations; and, (4) closing the trade at the first price convergence or, otherwise, at the end of the six-month trading interval. They also consider 29 strategy refinements that address industry affinity, frequency of past price divergence-convergence and/or magnitude of past price divergence. Using prices and industry designations for relatively liquid U.S. stocks over the period July 1962 through December 2009, they find that: Keep Reading

10-Month SMA Timing Signals Over the Short Run

The conclusion of “10-Month SMA Timing Signals Over the Long Run” is that 10-month simple moving average (SMA) timing signals (with current price above/below its 10-month SMA viewed as bullish/bearish) are mostly beneficial over the long run. However, this study involves complex modeling assumptions that limit confidence in its conclusion. How well do 10-month SMA crossing signals work for an investable proxy of the U.S. stock market over a recent sample period? To check, we test several variations of a 10-month SMA timing strategy on S&P Depository Receipts (SPY) since the introduction of this exchange-traded fund. Using daily and monthly closes for SPY, both unadjusted and adjusted for dividends, from inception in January 1993 through September 2010 and contemporaneous 3-month Treasury bill (T-bill) yields, we find that: Keep Reading

How Much Can High-frequency Traders Really Make?

Does high-frequency trading based on intensive data mining earn huge profits? In their September 2009 paper entitled “Empirical Limitations on High Frequency Trading Profitability”,  Michael Kearns, Alex Kulesza and Yuriy Nevmyvaka estimate the maximum possible profit from aggressive high-frequency trading (entry/exit via market orders with holding periods no longer than 10 seconds). They determine potential profit metrics based on high-resolution data for the most liquid NASDAQ stocks and then extrapolate to a large universe of U.S. stocks via regressions on less detailed data. They consistently err on the side of overestimation to define upper bounds on total available profit by: assuming perfect trader hindsight for trade selection; computing optimally profitable trade sizes;  excluding exchange fees and broker commissions; and, modeling opportunities in a way that overstates the number of profitable trades. Using a complete set of order placements, cancellations, modifications and trade executions for a set of 19 highly liquid NASDAQ stocks during 2008 and a less granular set of contemporaneous data for other U.S. stocks, they find that: Keep Reading

Evaluation of ChartsEdge Weekly Forecasts

Reader Mike Korell of ChartsEdge suggested an evaluation of his own S&P 500 Index forecasts for inclusion in Gurus. These “stock market forecasts are based on cycle data which has been analyzed by a Pattern Recognition Program. This use of artificial intelligence reduces the effect of personal bias and allows the simultaneous cycle analysis of many input variables.” To construct a statistical evaluation, we focus on the open and close levels of the ChartsEdge weekly forecasts, apparently issued on Sundays. Using estimates of the forecasted S&P 500 Index open and close levels from inspection of the ChartsEdge weekly charts and actual contemporaneous S&P 500 Index weekly open and close data for weeks beginning 9/8/08 through 9/7/10 (104 weekly returns), we find that: Keep Reading

Hindenburg Omens?

A reader asked: “Would you be willing to test or comment on the 8/14 Wall Street Journal article ‘Hindenberg Omen Flashes’?” The Hindenburg Omen is a complex technical signal that, including confirmation via clusters of signals, consists of simultaneous satisfaction of five rules for NYSE stocks. Different informal sources indicate some variation in the rules among practitioners. For the sake of consistency in rule application, we consider the “confirmed” Hindenburg Omens cited by Robert McHugh in his 8/21/10 article entitled “We Get An Official Confirmed Hindenburg Omen On August 20th, 2010”. This article states that, after Hindenburg Omens, “plunges can occur as soon as the next day, or as far into the future as four months.” Using the dates of the Hindenburg Omens reported in these articles and weekly closing levels of the S&P 500 Index during 1/3/86 through 8/13/10, we find that: Keep Reading

Momentum and Moving Averages for Currencies

A reader asked: “Does a combination of rotation by relative strength (momentum) and moving averages, similar to that described in Mebane Faber’s Ivy Portfolio, work for the main currencies?” Keep Reading

Simple Counter Trend Trade for the Stock Market?

A reader asked whether the counter trend trade for individual stocks as described on page 384 of David Aronson’s Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals applies also to the broad stock market. The trade comes from a “study that stocks that have declined sharply over the prior two weeks on declining volume display a systematic tendency to rise over the following week.” Since this trade utilizes two indicators, we check each indicator separately and then the combination of indicators. Using weekly prices and volumes for Standard & Poor’s Depository Receipts (SPY) as a tradable proxy for the broad U.S. stock market over the period February 1993 through July 2010 (913 weeks), we find that: Keep Reading

Testing Engulfing Candlesticks

A reader inquired about the predictive powers of bullish and bearish engulfing candlesticks, defined as: Bullish – a down day followed by an up day, with the latter having a higher intraday high and lower intraday low and closing in the top quarter of the daily range; and, Bearish – an up day followed by a down day, with the latter having a higher intraday high and lower intraday low and closing in the bottom quarter of the daily range. Using daily high, low and closing levels for the S&P 500 Index from January 1962 (the earliest available with intraday data) through July 2010, we find that: Keep Reading

A Few Notes on Harmonic Trading, Volume Two

In his 2010 book entitled Harmonic Trading: Volume Two Advanced Strategies for Profiting from the Natural Order of the Financial Markets, author Scott Carney “offers unprecedented strategies that identify the areas where overall trend divergence and harmonic pattern completions define the most critical technical levels. In addition, the new ideas presented in this material advance the basic theory of price pattern recognition by requiring other technical conditions to exist to validate potential opportunities with improved accuracy. Specifically, the advancement of the RSI BAMM separates the minor reactive moves from the more substantial trading opportunities and provides extensive technical information regarding the future potential direction of the price action. …Essentially, the integration of other measures has resulted in even more accurate projected reversal points for trade executions and hence, more reliable technical information regarding the state of potential price action. …The advanced techniques outlined in this book incorporate only the most pertinent technical measures that substantially increase the accuracy of harmonic patterns to identify the critical turning points in the financial markets.” On a chapter-by-chapter basis, key points from the book are: Keep Reading

A Few Notes on Harmonic Trading, Volume One

In his 2010 book entitled Harmonic Trading: Volume One, Profiting from the Natural Order of the Financial Markets, author Scott Carney presents “an important advancement of the gamut of technical trading strategies that seek to define opportunities in the financial markets through the identification of price patterns and the analysis of market structure. …Most important, Harmonic Trading possesses unique and effective technical measurement strategies that define critical new patterns and expound upon the existing knowledge base of general Fibonacci and price pattern theories to establish precise guidelines and extremely effective predictive tools to define and analyze market trends.” Focusing on the first three chapters, which provide background on the harmonic trading methodology, key points from the book are: Keep Reading

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