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Lecture6
TechnicalAnalysis:LinearTradingRules
HaksunLi
haksun.li@numericalmethod.com
www.numericalmethod.com
Outline
Movingaveragecrossover
Thegeneralizedlineartradingrule
P&Lsfordifferentreturnsgeneratingprocesses
Timeseriesmodeling
References
Emmanual Acar,StephenSatchell.Chapters4,5&6,
AdvancedTradingRules,SecondEdition.
ButterworthHeinemann;2ndedition.June19,2002.
AssumptionsofTechnicalAnalysis
Historyrepeatsitself.
Patternsexist.
DoesMAMakeMoney?
MovingAverageCrossover
Twomovingaverages:slow( ) andfast( ).
Monitorthecrossovers.
,
Longwhen
Shortwhen
.
.
HowtoChoose and ?
Itisanart,notascience(sofar).
Theyshouldberelatedtothelengthofmarketcycles.
Differentassetshavedifferent and .
Popularchoices:
(150,1)
(200,1)
AMA(n,1)
iff
iff
GMA(n,1)
iff
(bytakinglog)
iff
(bytakinglog)
Whatis ?
Acar Framework
Acar (1993):toinvestigatetheprobabilitydistribution
ofrealizedreturnsfromatradingrule,weneed
theexplicitspecificationofthetradingrule
theunderlyingstochasticprocessforassetreturns
theparticularreturnconceptinvolved
EmpiricalPropertiesofFinancialTimeSeries
Asymmetry
Fattails
KnightSatchellTranIntuition
Stockreturnsstayinggoingup(down)dependson
therealizationsofpositive(negative)shocks
thepersistenceoftheseshocks
Shocksaremodeledbygammaprocesses.
PersistenceismodeledbyaMarkovswitchingprocess.
KnightSatchellTranProcess
:longtermmeanofreturns,e.g.,0
, :positiveandnegativeshocks,nonnegative,i.i.d
KnightSatchellTran
1q
Zt =0
Zt =1
1p
StationaryState
,withprobability
,withprobability
GMA(2,1)
Assumethelongtermmeanis0,
NaveMATradingRule
Buywhentheassetreturninthepresentperiodis
positive.
Sellwhentheassetreturninthepresentperiodis
negative.
NaveMAConditions
Theexpectedvalueofthepositiveshockstoasset
return>>theexpectedvalueofnegativeshocks.
Thepositiveshockspersistency>>thatofnegative
shocks.
PeriodReturns
hold
0
0
1
Sellatthistimepoint
HoldingTimeDistribution
ConditionalReturnsDistribution(1)
UnconditionalReturnsDistribution(2)
LongOnlyReturnsDistribution
Proof:make
I.I.DReturnsDistribution
Proof:
1
make
ExpectedReturns
Whenistheexpectedreturnpositive?
,shockimpact
,shockimpact
1
,if
,persistence
GMA(,1)Rule
GMA(,1)ReturnsProcess
ReturnsAsaMA(1)Process
GMA(,1)ExpectedReturns
MAUsingtheWholeHistory
Aninvestorwillalwaysexpecttolosemoneyusing
GMA(,1)!
Aninvestorlosestheleastamountofmoneywhenthe
returnprocessisarandomwalk.
OptimalMAParameters
So,whataretheoptimal and ?
LinearTechnicalIndicators
Asweshallsee,anumberoflineartechnical
indicators,includingtheMovingAverageCrossover,
arereallythesamegeneralized indicatorusing
differentparameters.
TheGeneralizedLinearTradingRule
Alinearpredictorofweightedlaggedreturns
Thetradingrule
Long:
Short:
1,iff,
1,iff,
0
0
(Unrealized)rulereturns
if
if
1
1
BuyAndHold
PredictorProperties
Linear
Autoregressive
Gaussian,assuming isGaussian
Iftheunderlyingreturnsprocessislinear, yieldsthe
bestforecastsinthemeansquarederrorsense.
ReturnsVariance
MaximizationObjective
Varianceofreturnsisinverselyproportionalto
expectedreturns.
Themoreprofitablethetradingruleis,thelessrisky
thiswillbeifriskismeasuredbyvolatilityofthe
portfolio.
Maximizingreturnswillalsomaximizereturnsper
unitofrisk.
ExpectedReturns
TruncatedBivariateMoments
JohnstonandKotz,1972,p.116
Correlation:
Corr
ExpectedReturnsAsaWeightedSum
atermforvolatility
atermfordrift
Praetz model,1976
, thefrequencyofshortpositions
ComparisonwithPraetz model
Randomwalkimplies
.
theprobabilityofbeingshort
increasedvariance
BiasedForecast
Abiased(Gaussian)forecastmaybesuboptimal.
Assumeunderlyingmean
.
Assumeforecastmean
.
MaximizingReturns
Maximizingthecorrelationbetweenforecastandone
aheadreturn.
Firstordercondition:
FirstOrderCondition
Fittingvs.Prediction
If processisGaussian,nolineartradingrule
obtainedfromafinitehistoryof cangenerate
expectedreturnsoverandabove .
Minimizingmeansquarederror maximizingP&L.
Ingeneral,therelationshipbetweenMSEandP&Lis
highlynonlinear(Acar 1993).
TechnicalAnalysis
Useafinitesetofhistoricalprices.
Aimtomaximizeprofitratherthantominimizemean
squarederror.
Claimtobeabletocapturecomplexnonlinearity.
Certainrulesareilldefined.
TechnicalLinearIndicators
Foranytechnicalindicatorthatgeneratessignalsfrom
afinitelinearcombinationofpastprices
1 iff
Sell:
Thereexistsan(almost)equivalentARrule.
Sell:
1 iff
ln
ConversionAssumption
MonteCarlosimulation:
97%accurate
3%error.
ExampleLinearTechnicalIndicators
Simpleorder
SimpleMA
WeightedMA
ExponentialMA
Momentum
Doubleorders
DoubleMA
Returns:RandomWalkWithDrift
Thebiggertheorder,thebetter.
Momentum>SMAV>WMAV
Howtoestimatethefuture drift?
Crystalball?
Delphicoracle?
Results
Results
Returns:AR(1)
Autocorrelationisrequiredtobeprofitable.
Thesmallertheorder,thebetter.(quickerresponse)
Results
ARMA(1,1)
AR
MA
Pricestendtomoveinonedirection(trend)fora
periodoftimeandthenchangeinarandomand
unpredictablefashion.
Meandurationoftrends:
Informationhasimpactsonthereturnsindifferent
days(lags).
Returnscorrelation:
Results
nosystematic
winner
optimal
order
ARIMA(0,d,0)
Irregular,erratic,aperiodiccycles.
Results
ARCH(p)
aretheresiduals
When
,
.
residualcoefficientsasa
functionoflaggedsquared
residuals
AR(2) GARCH(1,1)
AR(2)
innovations
ARCH(1):lagged
squaredresiduals
lagged
variance
GARCH(1,1)
Results
Thepresenceofconditionalheteroskedasticity willnot
drasticallyaffectreturnsgeneratedbylinearrules.
Thepresenceofconditionalheteroskedasticity,if
unrelatedtoserialdependencies,maybeneithera
sourceofprofitsnorlossesforlinearrules.
Conclusions
Trendfollowingmodelrequirespositive(negative)
autocorrelationtobeprofitable.
Trendfollowingmodelsareprofitablewhenthereare
drifts.
Whatdoyoudowhenthereiszeroautocorrelation?
Howtoestimatedrifts?
Itseemsquickerresponserulestendtoworkbetter.
Weightsshouldbegiventothemorerecentdata.