1 5. Technical trading strategies 5.1 Introduction TA: various forecasting methods using past prices (volume, volatility). Note: look-ahead bias Edwards & Magee (2001), Kaufman (2005) Conflict with EMH yet “obstinate passion” (Menhkoff & Taylor (2007)). Lo et al (2000): TA (charting) fits well into human mode of cognition.

5. Technical trading strategies

3 5.2 Trend strategies Bar: duration (equal volume), opening/closing/minimum/maximum price. Trend motto: “buy low, sell high” Filter rules (naive strategy): Buy: P k /P k-1 > 1 + δ Sell: P k /P k-1 < 1 – δ One parameter: δ (threshold) Extension: Buy: P k /M k > 1 + δ, M k = max(P k-1,..., P k-n ) Sell: P k /m k < 1 – δ, m k = min(P k-1,..., P k-n ) Two parameters: δ and n. Used primarily as a benchmark.

4 5. Technical trading strategies 5.2 Trend strategies Moving-average rules Two moving averages (short and long): sma(P t, n) = (P t-1 + P t-2 +… + P t-n )/n r t = [sma(P t, S) - sma(P t, L)]/sma(P t, L) Buy: r t > δ Sell: r t < -δ Typical L/S ~ 4 – 20 ema(P t, β) = βP t + (1 - β) * ema(P t-1, β), β < 1 Starting with sma Adaptive MA (Kaufman (2005)), e.g. Chande’s MA: VIDYA t = βkP t + (1 - βk) * VIDYA t-1 k = stdev(P t, S)/stdev(P t, L)

5 5. Technical trading strategies

6 5.2 Trend strategies Channel breakouts Channel (or band): an area that surrounds a trend line within which price movement does not indicate formation of a new trend. The upper and bottom walls: resistance and support. Usual strategy: Buy: P t > (1 + B)M t-1 ; Sell: P t < (1 - B)m t-1 Risky strategy: Buy: P t > (1 + B)m t-1 ; Sell: P t < (1 - B)M t-1 Bollinger bands: trend line is SMA or EMA; B t = k stdev(P t, L) Usually k = 2 and L = 20.

5. Technical trading strategies

8 5.3 Momentum and oscillator strategies ( Price change) k-day momentum: M t = P t – P t-k Also, m t = P t – ema(P t, k) Moving Average Convergence/Divergence (MACD) MACD (line): MACD t = ema(P t, 12) – ema(P t, 26) signal line = ema(MACD t, 9) Buy: MACD crosses signal line from below. Sell: MACD crosses signal line from above. Diff MACD – signal_line => oscillator

9 5. Technical trading strategies

10 5. Technical trading strategies 5.3 Momentum and oscillator strategies Relative strength index (RSI) RSI - oscillator is determined by directional price moves during given time period N (usually N = 14 days) RSI = 100*RS/(1 + RS), RS = n up /n down Exponential smoothing: n up (t) = (1 - β)*n up (t-1) + βU(t), n down (t) = (1 - β)*n down (t-1) + βD(t) U(t) = 1, P t > P t-1 ; U(t) = 0, P t ≤ P t-1 D(t) = 1, P t < P t-1 ; D(t) = 0, P t ≥ P t-1 Typical RSI values for the overbought/oversold markets are 70/30. In volatile markets: 80/20.

5. Technical trading strategies

Money Flow Index (MFI) Volume-weighed RSI 1. Typical Price = (High + Low + Close)/3 2. Money Flow = Typical Price x Volume x UpDown UpDown = 1 (-1) when the market closes higher (lower) 3. Money Flow Ratio = (14-period Positive Money Flow)/(14-period Negative Money Flow) 4. Money Flow Index = /(1 + Money Flow Ratio) Market overbought (oversold) at MFI = 80 (20). 12

5. Technical trading strategies Stochastic oscillator %K = 100[(C - L14)/(H14 - L14)] C - the most recent closing price L14 - the low of the 14 previous trading sessions H14 - the highest price traded during the same 14-day period. %D = 3-period moving average of %K Trading signals occur when the %K crosses %D. 13

5. Technical trading strategies 5.4 Complex geometric patterns They include head-and-shoulders (HS), inverse HS, broadening tops and bottoms, triangle tops and bottoms, double tops and bottoms, a.o. Lo et al (2000): HS is determined with five consecutive extremes: E1, E2, E3, E4, and E5 such that E1 is a maximum; E3 > E1; E3 > E5; E1 and E5 are within 1.5% of their average E2 and E4 are within 1.5% of their average Omrane & Van Oppens (2004) define HS with nine rules including conditions for relative heights of the head and shoulders and timings between them. 14

5. Technical trading strategies Head-and-shoulders pattern 15

16 5. Technical trading strategies 5.5 Performance Simple TA strategies might be profitable in equities and in FX until 1980s and 1990s, respectively: Kerstner (2003), Aronson (2006), Neely et al (2009). Diversification: - Multiple time frames (Kaufman (2005)) - Mix of various strategies (Timmerman (2006), Hsu & Kuan (2005) ) - Mix of various instruments (Wilcox and Crittenden (2005)) - Mix TA with value analysis (Neely et al (2010))