People are interested in these financial instruments mainly because they are motivated to find the high returns of these instruments. Financial markets possess a fluctuating and volatile nature, which makes them appealing to a variety of people for different reasons, including investors who are attracted to them because of high returns and researchers who are eager to model market trends as a disciplined science to decipher future patterns.
These high returns over short periods of time are due to high volatilities in these particular markets. Today’s market technicians usually use technical analysis and related scientific tools to trade in the financial markets they specialize in. They use price charts and formulas to make trading decisions. Some market technicians use purely algorithms to make these objective decisions to enter and exit markets; this book concentrates on these algorithm technical indicators they design, test, and apply to the markets of their choice, for profit maximization. Algorithm trading models have evolved exponentially in recent years due to more rapid reactions to temporary mispricing and easier price management with computational trading systems, which can learn from thousands of information sources without the hindrance of human emotions. Thus, technical analysis, the methodology and science of deciphering past historical data to forecast future prices, has also grown to include machine learning methods, like the artificial neural network (ANN) approach.
The objective of this chapter is to provide a background of market analysis, which comprises fundamental and technical analyses which are the tools that market practitioners are using. It begins with the old trading rules and how they find and develop their way in technical analysis and modern finance. It traces the development of the need for more advanced technical analysis tool that may be of more value to today’s evolution of algorithm trading and the introduction of automated algorithm trading systems. The construction of a trading system begins with the age-old mechanical trading rules. The apprentice trader is guided to understand the beginning of constructing basic trading system.
Technical analysis is the study of historical prices. It observes the past behaviors to understand its current trend, which may give an indication of its immediate future direction (Murphy, 1999). Besides professional technical analysts, chartists, and fund managers, anyone who has an interest in the price movements will profit from the knowledge of technical analysis. Technical analysis is not an art for the few talented, gifted individuals as some chartists will lead the mass public to believe. It is a well-structured and organized science; that is, the same results can be replicated from the formulas and technical indicators by anyone. The foundation of technical analysis is built on the tenets observed by Charles Dow (Rhea, 1932).
To understand the basic and basis of technical analysis, it is important to start right at the base, at the foundation tenets. This chapter covers the introduction of using technical analysis approach to trading. To begin, this section defines the market technician who trades using Dow Theory and technical analysis.
Market Analysis
There are at least two conventional disciplines used by market practitioners to explain the behavior of market prices: technical analysis and fundamental analysis. The academia has a third theory called “Random-Walk” (Fama, 1965). Other methods that are gaining popularity are combinations of ANNs (Chan Phooi M’ng & Mehralizadeh, 2016), genetic programming, and adaptive methods with technical indicators (Chan Phooi M’ng, 2018).
Technical Analysis
Technical analysis researches the properties of the price series data empirically for patterns or trends to make trading decisions (Edwards & Magee, 2008). Technical analysis includes a variety of techniques such as chart analysis, pattern recognition, seasonality and cycle analysis, and algorithm technical trading systems.
One of the first foundations of technical analysis was laid down by Charles Dow in a series of Wall Street Journal editorials in the late 1800s. Although Dow, the editor of Wall Street Journal, wrote both technical analysis as well as fundamental reports on the market, his followers held onto his technical analysis of markets and named his observations Dow Theory (Rhea, 1932).
The views held by professional analysts, both technical analysts and the fundamental analysts, believe that certain trends exist in the market while the views held by traditional academicians subscribe to the theory that the randomness in historical prices series cannot be used to predict future prices in any meaningful way.
Traditionally, there are at least two major schools of thought regarding trends and the potential ability to profit from them, Dow Theory (technical analysis) and fundamental analysis. If there was a third school, it would be one that was attended by traditional academicians who advocated random walk theory. Mainstream academic research regards stock prices as random time sequences that contain noise (Fama, 1965). In contrast, market practitioners and proponents of technical analysis believe that past patterns and trends will be repeated in the future, and the skill and knowledge to identify these trends can be gainfully used to generate abnormal returns (Andrada-Felix & Fernandez-Rodriguez, 2008). Technical analysis establishes specific trading rules using specific indicators such as moving average to decipher behavioral patterns out of time-series data (Gencay & Stengos, 1998). Gencay and Stengos (1998) find that the key advantage behind the moving average rule is that it provides a means of determining the general direction or trend of a market based on historical behavior of stock prices. The added advantage of the moving average rule is the ability to capture information in nonlinear time-series prices that are usually ignored by methods that assume linearity.
As technical analysis develops into more rigorous, quantitative, and scientifically based research methods, new theories emerge. Computational algorithm trading systems may be the preferred trading systems of the day as they are used by the practicing professional market technicians in large institutions. Combination methods using technical rules and adaptive methods, genetic programming, and ANNs to find and create superior trading rules that generate net positive abnormal returns seem to be the latest trend in time series.
This section elaborates on these main ideas. First, the development of technical analysis begins with Dow Theory. Second, the basic tenets, principles, and concepts of technical analysis are explained. Third, technical analysis is compared with fundamental analysis. Fourth, these two investment methods are compared with random walk theory that deems technical analysis and fundamental analysis to be of no value since price series follow unpredictable random walks (Fama, 1965). Finally, with computer generations, combinations of technical rules involving genetic programming, ANN, and adaptive methods dominate the most current academic studies (Andrada-Felix & Fernandex-Rodriguez, 2008).
The first organized school of thought on movements of price series is Dow Theory (Rhea, 1932). Dow Theory is based on the observations and analysis of the US stock market by Charles Dow in a series of Review and Outlook editorials in The Wall Street Journal from the late nineteenth century to 1902. Charles Dow was the editor and founder of The Wall Street Journal and the creator of Dow Jones Industrial Average. Charles Dow, the part owner of Wall Street Journal, penned down his observations and analysis of the US stock market in a series of Review and Outlook editorials in the Wall Street Journal. His observations and analysis were later named the Dow Theory (Rhea, 1932) which proposes six tenets that became the core foundation of technical analysis.
The six basic tenets of Dow Theory are:
- 1.The averages (industrial and transportation) must confirm each other.
- 2.The averages discount everything.
- 3.The market has three movements.
- 4.The major trends have three phases.
- 5.Volume must confirm trend.
- 6.A trend continues until the signal reverses.
Th...