Question

Discuss the techniques of moving averages and filter rules as they are used by technical analysts. Include in your answer a discussion of technical analysis for an investor wishing to invest in emerging markets.

Answer 1

A trading system is a systematic method for buying and selling financial instruments with a view to consistently making money.

Technical analysis is an approach to predicting future price movements based on identifying patterns in prices, volume and other market statistics. Technical analysis usually proceeds by recording market activity in graphical form and then deducing the probable future trend from the pictured history.

Moving average trading refers to the practice of systematically buying and selling whenever the price crosses its average. The idea is that prices move in trends such that at each point in time the price is either in an uptrend or in a downtrend. An uptrend is defined as a period of 3 rising prices and a downtrend is defined as a period of falling prices. When the price cuts up through its average from below, because recent prices are higher than older prices, the price is said to be in an uptrend and a buy signal occurs. Similarly, when the price cuts down through its average from above, because recent prices are lower than older prices, the price is said to be in a downtrend and a sell signal occurs. The response following a buy signal is to buy and the response following a sell signal is to sell. If the change in the price level in between buy and sell signals is sufficient to cover costs, moving average trading is profitable. Conversely, if the change in the price level in between buy and sell signals is not sufficient to cover costs, moving average trading is loss making.

2.1 Technical analysis

Technical analysis is an approach to predicting future price movements based on identifying patterns in prices, volume and other market statistics. The philosophy underpinning technical analysis is that future prices are predictable from past prices as long as prices reflect changes in supply and demand. The approach is to detect trends as soon as possible and to trade in the trend direction.

The technical approach to investment is essentially a reflection of the idea that prices move in trends that are determined by changing attitudes of investors towards a variety of economic, monetary, political and psychological forces. The art of technical analysis, for it is an art, is to identify a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed.

Technical analysis differs from fundamental analysis. Fundamental analysis uses economic variables such as interest rates, valuation ratios and industry trends to predict future returns based on an economic model. Technical analysis uses past prices and other measures of the price to predict future returns based on extrapolating the price into the future. Fundamental analysis is usually concerned with predicting the long term and guides investment decisions. In contrast, technical analysis is usually concerned with predicting the short term and guides trading decisions. Fundamental analysis and technical analysis have little in common in this respect. See Welch and Goyal (2008) for a survey of return predictability based on economic variables.

To this end, technical analysis employs a number of techniques, the most common of which are charts, trading rules and cycle analysis. Charting relies on detecting graphical patterns in the price. Patterns are usually defined as reversal and continuation patterns. Reversal patterns include the head and shoulders, double tops/bottoms and rounded tops/bottoms. Continuation patterns include flags, pennants, wedges and rectangles. Studies of charting are often limited by the need to design a pattern recognition algorithm to extract the patterns although studies of charting are becoming increasingly common. See, for example, Lo et al. (2000), Dempster and Jones (2002), Dawson and Steeley (2003), Wang and Chan (2007, 2009) and Leigh et al. (2008). The general result is that there is evidence of predictive ability. It is not clear to what extent this equates to profitability however.

Because they are mathematically tractable, the majority of studies of technical analysis are presented in the form of trading rules. As defined in Chapter 1, a trading rule is a numerical method that maps the price onto investment decisions. Trading rules are based on technical indicators where a technical indicator is a quantitative function of the price state. Technical indicators include moving averages, momentum oscillators and volume indicators. Example momentum oscillators are the %K stochastic and the relative strength index (RSI). Example volume indicators are the on balance volume and the money flow index. See Achelis (2001) for an overview of the more popular technical indicators. Trading rule studies include Mills (1997), Sullivan et al. (1999), Day and Wang (2002), Kwon and Kish (2002), Olson (2004), Marshall and Cahan (2005) and Marshall et al. (2009). The general result is that while there is evidence of predictive ability, the trading rules are rarely profitable after costs.