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.

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5. Technical trading strategies
5. Technical trading strategies

5.2 Trend strategies

Bar: duration (equal volume), opening/closing/minimum/maximum price.
Trend motto: buy low, sell high.

5.2.1 Filter rules (naive strategy):

Buy: Pk/Pk-1 > 1 +
Sell: Pk/Pk-1 < 1
One parameter: (threshold)

Extension:
Buy: Pk/Mk > 1 + , Mk = max(Pk-1, ..., Pk-n)
Sell: Pk/mk < 1 , mk = min(Pk-1, ..., Pk-n)
Two parameters: and n.
Used primarily as a benchmark. 3
5. Technical trading strategies
5.2 Trend strategies
5.2.2 Moving-average rules
Two moving averages (short and long):
sma(Pt, n) = (Pt-1 + Pt-2 + + Pt-n )/n
rt = [sma(Pt, S) - sma(Pt, L)]/sma(Pt, L)
Buy: rt >
Sell: rt < -
Typical L/S ~ 4 20

ema(Pt, ) = Pt + (1 - ) * ema(Pt-1, ) , < 1

Starting with sma

Adaptive MA (Kaufman (2005)), e.g.

Chandes MA: VIDYAt = kPt + (1 - k) * VIDYAt-1

k = stdev(Pt, S)/stdev(Pt, L)
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5. Technical trading strategies

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5. Technical trading strategies
5.2 Trend strategies
5.2.3 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: Pt > (1 + B)Mt-1; Sell: Pt < (1 - B)mt-1

Risky strategy: Buy: Pt > (1 + B)mt-1; Sell: Pt < (1 - B)Mt-1

Bollinger bands:
trend line is SMA or EMA;
Bt = k stdev(Pt, L)
Usually k = 2 and L = 20.
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5. Technical trading strategies
5. Technical trading strategies
5.3 Momentum and oscillator strategies
(Price change) k-day momentum: Mt = Pt Pt-k
Also, mt = Pt ema(Pt, k)

5.3.1 Moving Average Convergence/Divergence (MACD)

MACD (line): MACDt = ema(Pt, 12) ema(Pt, 26)

signal line = ema(MACDt, 9)
Buy: MACD crosses signal line from below.
Sell: MACD crosses signal line from above.

Diff MACD signal_line => oscillator

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5. Technical trading strategies

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 5. Technical trading strategies

5.3 Momentum and oscillator strategies

5.3.2 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 = nup/ndown

Exponential smoothing:
nup(t) = (1 - )*nup(t-1) + U(t), ndown(t) = (1 -
)*ndown(t-1) + D(t)
U(t) = 1, Pt > Pt-1; U(t) = 0, Pt Pt-1 D(t) = 1, Pt <
Pt-1; D(t) = 0, Pt Pt-1

Typical RSI values for the overbought/oversold markets are 70/30.

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In volatile markets: 80/20.
5. Technical trading strategies
 5. Technical trading strategies

5.3.3. 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 = 100 - 100/(1 + Money Flow Ratio)

Market overbought (oversold) at MFI = 80 (20).

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 5. Technical trading strategies

5.3.4 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.

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

94

92
Left shoulder Right shoulder

90
Price

88

86
Sell!

84

82
4/27/2009 5/7/2009 5/17/2009 Neckline
5/27/2009 6/6/2009 6/16/2009 6/26/2009 7/6/2009 7/16/2009
4/22/2009 5/2/2009 5/12/2009 5/22/2009 6/1/2009 6/11/2009 6/21/2009 7/1/2009 7/11/2009

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 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))

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