Effective Trading in Financial Markets Using Technical Analysis

Smita Roy Trivedi, Ashish H. Kyal

• Publisher: Routledge India
• Year: 2020
• ISBN:
  9781000205190
• Edition: 1
• Topic: Economia
• Subtopic: Teoria economica

This book provides a comprehensive guide to effective trading in the financial markets through the application of technical analysis through the following:

• Presenting in-depth coverage of technical analysis tools (including trade set-ups) as well as backtesting and algorithmic trading

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• Discussing advanced concepts such as Elliott Waves, time cycles and momentum, volume, and volatility indicators from the perspective of the global markets and especially India

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• Blending practical insights and research updates for professional trading, investments, and financial market analyses

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• Including detailed examples, case studies, comparisons, figures, and illustrations from different asset classes and markets in simple language

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The book will be essential for scholars and researchers of finance, economics and management studies, as well as professional traders and dealers in financial institutions (including banks) and corporates, fund managers, investors, and anyone interested in financial markets.

1
INTRODUCTION TO TECHNICAL ANALYSIS

The Only Game in Town.

– Mohamed A. El-Erian¹

1.1 Technical analysis and trading in the financial markets

What is your game? The fascination of our times with the financial markets and efforts to ‘beat the market’ makes trading no less than an adrenalin-pumping sport. Trading is a game, played solo with the rest of the market! And technical analysis is the much-needed skill to win consistently in the game of trading.

At the core of trading is the idea that assets are not valued correctly which makes it possible to buy an undervalued asset (sell an overvalued one) and thereby reap gains from the price rise (fall). If markets always determined the true value of a security, as markets would do if they were ‘efficient’, it would be impossible to ‘beat the markets’. However, the efficiency paradigm of the financial markets has largely been questioned (Thaler, 2015), and astute traders know that while we cannot be right in our valuation every time and ‘beat the market’, it is possible, with the right strategy, to outwit the market and make profits.

Technical analysis is one of the essential strategies, which when rightly used, can help traders to make profits and win in the trading game. The fascination with technical analysis as a skill set for trading in markets is reflected in not only the growing literature on technical analysis but also the copious advice that pours through blogs and forums to traders. This book is all about using technical analysis effectively to make our mark in trading.

What is technical analysis? Technical analysis encompasses several loosely held paradigms, all of which are based on the analysis of a financial asset’s price and volume data to predict its future movement. Depending on the technical analysis approach, the analysis of price and volume data involves visualization on charts and/or calculation of various statistical measures of the data. At the core of technical analysis is the idea that the market movement of an asset in the future is predictable on the basis of the past, and price (and volume) data alone suffice for such prediction. Fundamental analysis of assets, on the contrary, would juggle with several variables for predicting prices. The focus on price (and volume) frees us from the cacophony of other variables, undoubtedly, adding to the popularity of technical analysis.

Placing a successful trade requires an understanding of where prices are heading. Trading effectively is all about forecasting correctly the future price movement. A trader will buy the security, the price of which is expected to move up and sell the one, whose price is expected to fall. Similarly, traders in the foreign exchange market will buy the currency expected to appreciate and sell the one expected to depreciate.

Traders commonly use fundamental analysis or technical analysis or a combination of both to forecast the future market movements. Fundamental analysis is a systemic study of the factors that can impact the price of an asset to predict the future price of the asset. Investment or trading in an asset class requires a knowledge of the economic factors that move the asset. For equities, the valuation will majorly depend on company-specific factors, most importantly the financials of the company and macroeconomic factors that impact the specific industry. For currencies, a host of macroeconomic factors (economic and non-economic) impact the appreciation or depreciation of the currency. The factors impacting the assets are frequently modelled and used to forecast future prices. Contrasted with this, technical analysis is the methodological study of charts and price movement to forecast prices in any market. It considers market action as reflected in chart patterns and predicts the future movement of prices based on a specific assumption regarding the previous patterns. The most important assumption underlying such a prediction is that the chart patterns seen are repetitive in nature and therefore they can be used to successfully predict the future movement.

Thus, while fundamental analysis delves into why the market moved the way it did, technical analysis is unconcerned about the causes of market movement. Fundamental analyses of markets thus look at the reasons why the markets have moved. For example, fundamental analysis of foreign exchange markets considers all the factors that can impact exchange rate determination while that for equity markets looks at the macroeconomic variables and company-specific factors relevant to that stock. This is in contrast to technical analysis which is not concerned about why markets have moved in the way they have. Technical analysis asks, ‘If markets have moved as can be seen from the charts, can we predict the way it will move in the future?’

In this chapter, we present a comprehensive view of the technical analysis paradigm. We will look at the evidence on the use of technical analysis by professionals and research on the profitability of technical analysis. The empirical evidence on technical analysis lends support to the widespread use of technical analysis by professionals. With this we also place technical analysis in the context of the Efficient Market Hypothesis (EMH). To aid our understanding of technical analysis, and its effective use, we wrap up this chapter with a discussion on the financial market infrastructure required for trading.

1.2 Evidence on the use of technical analysis

If you are a novice to trading or a student, you may have googled the term technical analysis and been flummoxed at the number of web resources available on the subject: from books and articles to blogs, forums, and websites. If you are a trader (retail or institutional), you must have had countless strategies discussed and shared by peers on technical trading. And you know that technical analysis is incredibly popular amongst traders, which is presumably also the reason you are reading this book.

Is there a fascination that professional traders have for technical analysis? Yes indeed, technical analysis remains an ‘obstinate passion’ (Menkhoff and Taylor, 2007) for trading professionals. One of the most intriguing areas of mainstream finance is that this popularity of technical analyses among practitioners is despite technical analysis not being anchored to any underlying economic or financial theory (Hsu, Taylor, and Wang, 2016).

How important is technical analysis to traders? Allen and Taylor (1990) presented some of the earliest evidence on the use of technical analysis by professionals, in this case chief forex dealers in the London market. The paper showed that chartism, or use of technical charts by market participants for forecasting, dominated the short-term horizon predictions. Of respondents, 90% used charts for forecasts for the short-term (intra-day to one-week) horizon. While for long-term (one- and three-month) forecasts, the inclination to use fundamental analysis increased, only 30% of respondents were depending ‘on pure fundamentals’. The paper presented compelling evidence of the complementarity between technical and fundamental analysis in the minds of traders.

While the evidence on the use of technical analysis brought forth interest in why technical analysis can work, to which we will come later on, a series of studies followed, lending support to the extensive use of technical analysis amongst traders (Menkhoff and Taylor, 2007, 2010; Cheung, Chinn, and Marsh, 2004, Cheung and Chinn, 2001; Oberlechner, 2001; Cheung and Wong, 2000; Hsu et al., 2016). Cheung and Chinn (2001) reported that, in a survey of US dealers, technical trading best describes 30% of trading behaviour, a slightly greater proportion than that attributed to fundamental analysis (25%), followed by customer-order-driven (22%) or ‘jobbing’² (23%).

Gehrig and Menkhoff (2006), in a survey covering forex dealers and fund managers, showed that technical analysis has gained traction over time, being most important in forex dealing and second in fund management. The recent evidence on the use of technical analysis suggests that this trend has continued. Menkhoff (2010) shows in a survey of 692 fund managers in five countries that not only do a majority of them use technical analysis but that at a forecasting horizon of weeks, technical analysis is also the most important form of analysis and considered more important than fundamental analysis.

Technical analysis seems to largely dominate over fundamental analysis in shorter trading horizons (Allen and Taylor, 1990; Cheung and Chinn, 2001; Gehrig and Menkhoff, 2006; Menkhoff, 2010). Gehrig and Menkhoff (2006) show that charts are used for shorter-term forecasting horizons while flows dominate at the shortest term and fundamentals at a longer horizon. Cheung and Wong (2000), in a survey covering the forex market in Hong Kong, Tokyo, and Singapore, report 40% of the respondents saying that technical trading is the major factor determining exchange rates in the medium run. This study contends that short-run exchange rate dynamics depend on a host of non-fundamental forces in addition to technical trading (bandwagon effects, overreaction to news, and excessive speculation).

Traders hardly neglect the fundamental factors even when following technicals staunchly. In fact, technical and fundamental analysis may be more complementary than initially thought (Cheung et al., 2004; Cheung and Wong, 2000; Gehrig and Menkhoff, 2006). Cheung et al. (2004), covering the UK-based dealers, iterated that there was little evidence of a systematic difference of opinion between chartists and fundamentalists. Gehrig and Menkhoff (2006) point out that professionals rely on both fundamental and technical analysis, in addition to flow analysis. Cheung and Wong (2000) argue for combining fundamentals and non-fundamentals in a unified model for both short-run and long-run exchange rate dynamics. In the present global economic system with integration in financial markets, news events often have a destabilizing impact on the financial markets. An awareness of what goes on behind the chart movement is crucial even when trading on the basis of technicals alone. While fundamentals and technicals have different approaches to understanding market movement, for the trader, the use of both is concerned with how to predict future prices.

1.3 Technical analysis profitability and the efficient market paradigm

The extensive evidence on the use of technical trading by professionals is not surprising given the compelling evidence for the profitability of technical analysis. In one of the major empirical studies on profitability of technical analysis indicators, Brock, Lakonishok, and LeBaron (1992) showed, using technical analysis based on filter techniques, that profit can be generated substantially in excess of buy-and-hold returns. Other studies confirmed that technical analysis served as an important tool in the hands of market practitioners in enabling effective trading decisions (Pinches, 1970; Menkhoff and Taylor, 2007; Surajaras and Sweeney, 1992; Menkhoff and Schlumberger, 1995; Neely, Weller, and Dittmar, 1997; LeBaron, 1999; Saacke, 2002). In a recent study, Hsu et al. (2016) used daily data from over 45 years for 30 developed and emerging market currencies to examine the profitability of more than 21,000 technical trading rules in the foreign exchange market. They find evidence of substantial predictability and excess profitability in both developed and emerging currencies when measured against a variety of performance metrics.

The evidence on the profitability of technical analysis challenges the basis of the EMH. Are financial markets efficient? The debate over the efficient market paradigm is one of the most interesting deliberations in financial economics. The seeds of efficiency paradigm were sown in Paul Samuelson’s analysis of random walk in 1965, but it is Fama’s seminal paper in 1970 which formalized the paradigm with its theoretical and empirical evidence, iterating that the efficient market model, ‘but with a few exceptions[,] … stands up well’ (Fama, 1970). In Fama’s construct, an efficient market is a market in which prices always ‘fully reflect’ all available information.

However, as evidence on stock market anomalies grew (Dimson and Mussavian, 1998), it became hard to believe that the anomalies are exceptions and prices do indeed reflect ‘all information’. Soon the evidence on long-term mispricing in equity markets, one of the strongest coming from De Bondt and Thaler in 1985, challenged the core of the ef...