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Study of Predictive power of Moving Averages as a tool of Technical Analysis Jyotika Bahl Research Scholar University of Delhi, India Email: jyotikadsedu@gmail.com
I.
forms such as lines of support, resistance,
Introduction:
Technical analysis uses past prices in order
channels, and more obscure formations
to predict future prices. It tries to detect
such as flags, pennants, balance days and
some predefined "patterns" in price series,
cup
and claims it is capable of exploiting the
analysis is widely used among traders and
trends that it discovers.1 The methodology
financial professionals and is very often
of technical analysis rests upon the
used by active day traders, market makers
assumption that history tends to repeat
and pit traders. In the 1960s and 1970s it
itself in the stock exchange. If a certain
was widely dismissed by academics. In a
pattern of activity has in the past produced
recent review, Irwin and Park reported that
certain results nine times out of ten, one
56 of 95 modern studies found that it
can assume a strong likelihood of the same
produces positive results but noted that
outcome whenever this pattern appears in
many of the positive results were rendered
the future. It should be emphasised,
dubious by issues such as data snooping,
however,
the
so that the evidence in support of technical
methodology of technical analysis lacks a
analysis was inconclusive; it is still
strictly logical explanation. Technicians
considered by many academics to be
using charts search for archetypal price
pseudoscience. Academics such as Eugene
chart patterns, such as the well-known
Fama say the evidence for technical
head and shoulders or double top/bottom
analysis is sparse and is inconsistent with
reversal
technical
the weak form of the efficient-market
indicators, moving averages, and look for
hypothesis. Users hold that even if
that
a
patterns,
large
part
study
of
and
handle
patterns.
Technical
technical analysis cannot predict the 1
Anderson John’s study.
future,
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it
helps
to
identify
trading
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opportunities. A fundamental principle of
a broad upward or downward movement
technical analysis is that a market's price
that may last for a year or two, whereas the
reflects all relevant information, so their
intermediate trends are corrective trends
analysis looks at the history of a security's
which may last for three weeks to three
trading pattern rather than external drivers
months. When the market exhibits the
such as economic, fundamental and news
increasing trend it is a bull market. The
events. Therefore, price action tends to
bull market is operational when a new high
repeat itself due to investors collectively
is higher than previous high and new low
tending toward patterned behavior – hence
is higher than previous low. The short term
technical analysis focuses on identifiable
trends refer to the day to day price
trends and conditions.
movements. 2. Point and Figure Charting
Techniques of Technical Analysis
Point and Figure charting is a technical analysis technique in which time is not
1. Dows theory
represented on the x-axis, but merely price
Dow developed his theory to explain the
changes
movement of the indices of Dow Jones
recorded via a series of X’s for increasing
Average. He developed the theory on the
price movements and O’s for decreasing
basis of three hypotheses, first being, that
price movements.
(independent
of
time)
are
no single individual or buyer can influence the major trend in the market. However an individual investor can affect the daily
Figure 1: Example of a Point and Figure
price movement by selling or buying huge
Chart
quantum of particular scrip. His second
53
X
hypothesis
discounts
52
X
everything, even a natural calamity such as
51
X
earthquake, plague, fire gets discounted in
50
the market.
49
X
48
X
divided into primary, intermediate and
47
X
short term trend. The primary trend may be
46
is
that
market
According to the theory the trend is
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X
X
X
X
O
X
O
X
O
X
O
X
O
X
O
X
O
O
O
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beyond the local maxima (minima) and that the stronger demand (supply) will Evidence suggests that the technique is
persist. Consequently the continued buying
over 100 years old and is now a standard
(selling) should cause prices to increase
feature on many widely-used professional
(decrease) so producing a profitable
market analysis software systems such as
trading opportunity.
Bloomberg, Reuters, Trade Station and Meta Stock.
The trading rules adopted
3. Moving Average
here were applied in Davis (1965) and are
The underlying trend of the movement of
reproduced below labelled as buy signals
prices can be studied by smoothening the
and as sell signals.
data. To smooth the data moving average technique is used. Buy and sell signals are provided by the moving average. The
Figure 2: Double Top (Buy Signal)
stock price may intersect the moving
Figure 3: Double Bottom (Sell)
average at a particular point. Downward
X X
X
X
O
X
X
O
X
X Buy
O
X
O
O
X
O
O
O
O
Sell
O penetration of the rising average indicates
The
Double
Top
(Double
Bottom)
formation is, by definition, the most widely observed trading pattern in Point and Figure as all of the more sophisticated patterns discussed below must contain this basic pattern. The formation occurs by prices rising above (below) the previously established highest price. It implies that prices trading above (below) a previous high (low) suggest that the market is subject to an increase in demand (supply)
the possibility of a further fall. Hence a sell
signal
is
generated.
Upward
penetration of a falling average would indicate the possibility of further rise and give a buy signal. When long term and short term moving averages are drawn, the intersection of two moving averages generates buy or sell signals. When the scrip price is falling and if short term average intersects the long term moving average from above and falls
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below it, the sell signal is generated. If the
of the bear market. But the result should be
scrip price is rising, the short term moving
confirmed with volume and trend.
average would be above the long term average. The short term average intersects the long
term
average from
Figure 5: Double Top
below
600
indicating a further rise in price, gives a
500
buy signal.
400 300
4. Head and Shoulders approach
Series1
200
In the head and shoulders pattern there are
100
three rallies resembling the left shoulder, a
0 1
head and a right shoulder. A neckline is
3
5
7
9 11 13
drawn connecting the lows of the tops. When the stock price cuts the neckline
In a double bottom, the price of the stock
from above, it signals the bear market.
falls to a certain level and increases with
The upward movement of the price for
diminishing activity. Then it falls again to
some duration creates the left shoulder. At
the same or to a lower price and turns up to
the top of the left shoulder people who
a
bought during the uptrend begin to sell
resembles letter ’W’.
resulting in a dip. Near the bottom there
view double bottom as a sign for bull
would be reaction and people who have
market.
higher
level.
The
double
bottom
Technical analyst
not bought in the first uptrend start buying at relatively low prices thus pushing the
Figure 6: Double Bottom
price upward. The alternating forces of
600
demand and supply create ups and lows.
500 400 300
5. Double top
Series1
200
If the double top is formed when a stock
100
price rises to a certain level, falls rapidly,
0
again rises to the same height or more, and
1 3 5 7 9 11
turns down. Its pattern resembles the letter ‘M’. The double top may indicate the onset
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6. Support and Resistance Level
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Support levels exist at a price where considerable demand for stock is expected
II.
Hypothesis
to prevent further fall in the price level. In
Technical analysis cannot be used to
the support level demand for the particular
predict the volatility in prices of BSE
scrip is expected. In resistance level the
index, and thus cannot correctly produce
supply of the scrip would be greater than
buy/ sell signals.
the demand and further rise in price is prevented. The selling pressure is greater
III.
Literature Review:
and the increase in price is halted for the
1. Anderson’s Study 2
time being. When the stock touches a
The paper extensively discusses the point
certain level and then drops, this is called
and figure charting technique of technical
resistance and if the stock reaches down to
analysis. This paper reiterates the eight
certain level and then rises there exist a
Boolean statements which spell out the
support.
price moment when a prudent investor
This can be explained numerically say, for
should buy and sell shares. These signals
example, if a scrip price hovers around Rs.
are valuable to any investor so as to make
150 for some weeks, then it may rise and
decision whether to enter the market at the
reach Rs. 210. At this point the price halts
right time basing the decisions on the
and then falls back. The scrip keeps on
movement of share prices or to exit the
falling back to around its original price Rs.
market in order to avoid losses. The paper
150 and halts. Then it moves upward. In
introduces two concepts of Point per Box
this case Rs. 150 becomes the support
(PPB) which indicates what level of price
level. At this price, the scrip is cheap and
sensitivity have to be recorded in the box
investors buy it and demand makes the
and the Reversal Size specifying how
price move upward. Whereas Rs. 210
many boxes the price needs to reverse by
becomes the resistance level, the price is
before new price change is recorded. A
high and there would be selling pressure
time series of S&P 500 future contract
resulting in the decline of the price.
from 1990 to 1998 was picked up to
This paper concentrates on the moving averages as a technique for technical Analysis
for
predicting
generated by the stock price.
the
signals
2
Anderson John, Point and Figure Charting: A Computational Methodology and Trading Rules Performance in the S & P 500 Future Market, QUT School of Economics and Finance Discussion Paper No. 01-01.(2001)
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analyse and present results using point and
when the price of the asset crosses
figure charting.
above the moving average while the second strategy issues a `buy' signal
2. Detry’s (2001)
when a faster moving average crosses
This paper highlights that simple
above a slower moving average; `sell'
techniques of moving averages help to
signals are defined in the opposite
predict the share price. This paper
direction. If the strategies are `long
picks 15 countries of European Union
only' ones then an `exit' signal (usually
to produce a comparative analysis of
reverting to a risk-free asset) is issued.
the results generated by using a
Besides the plain moving average the
Variable Moving Average (VMA). An
paper employs an exponential and
unbiased selection of indexes is made
weighted moving average. An equity
from each country to test the technique
series of Dow Jones and S&P 500
and interpret the results. T-tests were
indices and six series of exchange
employed to evaluate whether returns
traded funds were used to evaluate the
following buy signals are higher than
method.
returns following sell signals, and 4. Marshall and Cahan’s Study3
whether those buy (sell) returns are different from the unconditional return.
This paper attempts to add to the existing
The study was able to establish the
literature by investigating the profitability
results for 13 countries with two
of technical trading rules in the 49
countries as exceptions where the
developed and emerging market indices
moving averages could not assist in
that make up the Morgan Stanley Capital
prediction of correct volatility signals.
Index (MSCI). The study also states that
In 11 cases this predictive power is
recent data should be used as past studies
statistically significant, and in 10 cases
prove that historical series is less relevant
this result is robust to risk adjustment.
to academicians and practitioners. The analysis reveals that emerging markets
3. Thomakos and Papailias’s (2011)
have, on an average, outperformed their
This
developed market counterparts over the
paper
introduces
two
new
strategies based on a price cross-over and on moving averages cross-over. The first strategy issues a `buy' signal
3
Marshall Ben, Cahan Jared, Technical Analysis around the World, Working Paper Series, Massey University, New Zealand, 2010.
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period of study but they also involve
1986. The study provides a strong support
higher risk.
for
We cannot rule out the possibility that
consistently generate higher return than
technical
to
sell signals, and further the returns
compliment other investment techniques,
following the buy signals are less volatile
or that trading rules other than the ones we
than sell signals. Moreover the returns
examine are profitable.
following sell signals are negative.
analysis
can
be
used
5. Caginalp and Balenovich’s Study4 This paper presents a description of the theoretical
foundations
of
technical
analysis and also explains how charts could suggest a buy/ sell signal. The movement of the stock prices reflect the notion of the investor in relation to the stock. In case the investor perceives the stock highly then the stock market might show an upward trend in the stock prices. The
author
highlights
that
technical
analysis assumes that stock prices reflect all publicly available information hence enabling the investor to carve out signals of buy/ sell. 6. Brock and Baron’s Study5 This paper test two simple trading rulesmoving averages and trading range break by utilizing Dow Jones Index from 1897 to 4
Caginalp and balenovich, A Theoretical Foundation for Technical Analysis, Journal of Technical Analysis, 2003. 5 Brock and Baron, (1992), Simple Technical Trading and the Stochastic properties of Stock Return, Journal of Finance, Volume 47, Issue 5, 1731-1764.
technical
IV.
strategies.
Buy
signals
Research Methodology
Since the article of Brock, Lackonishok and LeBaron (BLL thereafter) (1992), showing that simple forms of technical analysis can significantly predict daily price movements of the Dow Jones index, many academics have begun to realize that technical analysis might have some value. We chose to evaluate the 10 VMA (variable length moving averages) rules of BLL. Those rules consist of comparing a short moving average of the price with a long moving average. When the short moving average (over 1, 2 or 5 days) is above the long moving average (over 50, 150 or 200 days) plus a certain percentage band, the next day is considered as a buy day. Conversely, when the short average is below the long average minus the band, the next day is classified as a sell day. Following BLL, we evaluate the following VMA:
(1,50,0),
(1,200,0),
(1,150,0),
(2,200,0),
(5,150,0), (1,50,0.01),
(1,150,0.01), (5,150,0.01), (1,200,0.01),
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(2,200,0.01), where the first and second
moving averages is to smooth out an
figure represent the number of days over
otherwise volatile series. When the short
which the short and long moving averages
run moving average penetrates the long
are computed, respectively, and where the
run moving average, a trend is considered
third figure is the value of the band. The
to be initiated. The most popular moving
reason why we chose to evaluate only
average rule is 1-200, where the short
VMA rules (and not the FMA, fixed length
period is one day and the long period is
moving averages, nor TRB, trading range
200 days. While numerous variations of
break-out) is because the results obtained
this rule are used in practice, we attempt to
by VMA rules in BLL were much more
select several of the popular ones: 1-50, 1-
significant.
150, 5-150, 1-200 and 2-200. The moving average decision rule is often modified by
V.
Data sources and Results
1. Data We chose to evaluate the forecast power of technical rules on BSE index, using daily data, to replicate BLL. Daily market return of BSE 30 from 1st Jan 2008 to 30th Oct 2013 is chosen for this purpose. The
introducing a band around the moving average. The introduction of a band reduces the number of buy (sell) signals by eliminating the “whiplash� signals when the short and the long run moving average are close. We test the moving average rule both with and without a one percent band.
closing prices are considered for the BLL
Variable length moving average (VMA),
test consisting of 1448 values in our study.
initiates buy (sell) signals when the short
2. Technical Trading rules
run moving average is above (below) the long run moving average by an amount
According to the moving average rule, buy
larger than the band. If the short run
and sell signal are generated by two
moving average is inside the band no
moving averages of the level of the index-
signal is generated. This method attempts
a long run average and a short run average.
to generate a strategy where traders go
In its simple form this strategy is
long as the short moving average moves
expressed as buying (or selling) when the
above the long and short when it is below.
short period moving average rises above
With a band of zero this method classifies
(or falls below) the long run moving
all days into either buys or sells. Other
average. The idea behind computing
variations of this rule put emphasis on the
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crossing of the moving averages. They
are presented in Table 1. The rules differ
stress that the return should be different for
by the length of the short and long period
a few days following a crossover. To
and by the size of the band. For example,
capture this we test a strategy where a buy
(1, 200, 0) indicates that the short period is
(sell) signal is generated when the short
one day, the long period is 200 days, and
moving average cuts the long moving
the band is zero percent. We present
average from below (above). This is
results for the 10 rules that we examined.
referred to as the fixed moving average.
The moving average rule is used to divide
There are numerous variations of moving average that we do not examine. Other variants of moving average rule also consider the slope of the long length moving average in addition to whether the short period moving average penetrates from above or below. In other versions changes in trading volumes are examined before buy (sell) decisions are reached. Thus, numerous moving averages rules can be designed and some without doubt will work. However the danger of data snooping is immense. To implement the trading range strategy, we defined rules in accordance with the moving average strategy. Maximum (or minimum) prices were determined based on the past 50, 150 and 200 days. In addition, the rule is implemented with or without a percent band. 3. Results: The Moving average strategy Results from trading strategies based on moving average rules for the full sample
the entire sample into either buy or sell periods depending on the relative position of the moving averages. If the short run moving average is above (below) the long, the day is classified as buy (sell). This rule is designed to replicate returns from a trading rule where the trader buys when the short moving average penetrates the long from below and stays in the market until the short moving average penetrates the long moving average from above. After this signal the trader moves out of the market or sells short. This rule is referred as Variable Moving Average (VMA). In Table 1 we report the daily returns during the buy and sell periods and the corresponding t- statistics. The last column lists the differences between the mean daily buy and sell returns. All the buy -sell differences are negative and the t-test for these differences are highly significant. In one case the introduction of one percent band increased the spread between buy and
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sell returns. The first two columns
generated.
represent the number of buy and sell Table 1: Standard test results for the variable-length moving average (VMA) rules Test (1,50,0)1
N(Buy) 736
N(sell) 711
(1,150,0) 725
722
(1,200,0) 720
727
(5,150,0) 719
728
(2,200,0) 719
728
(1,50,1)
736
79
(1,150,1) 725
721
(1,200,1) 721
726
(5,150,1) 721
722
(2,200,1) 721
725
Buy2 0.15 (1.708951)*** 0.15 (1.712794) *** 0.13 (1.405119) 0.02 (0.078583) 0.14 (1.537061) 0.16 (1.751093) *** 0.16 (1.736102) *** 0.13 (1.434032) 0.03 (0.203258) 0.14 (1.583814)
Sell -0.12 (10.78103)* -0.11 (10.8769)* -0.09 (11.22656)* 0.01 (12.54687)* -0.10 (11.10443)* -0.12 (10.77104)* -0.12 (10.86103)* -0.09 (11.21107)* 0.01 (-0.0451) -0.10 (11.07747)*
Buy>0 0.55
Sell>0 0.47
0.54
0.47
0.55
0.49
0.52
0.49
0.53
0.49
0.55
0.47
0.54
0.47
0.55
0.47
0.52
0.50
0.53
0.49
Buy-sell3 -0.27 (-7.91668)* -0.27 (-7.94479)* -0.22 (-8.48892)* -0.01 (-10.7763)* -0.24 (-8.26377)* -0.28 (-7.87756)* -0.27 (-7.91247)* -0.22 (-8.45551)* -0.02 (0.21504) -0.25 (-8.21162)*
1 Rules
examined representing (short moving average, long moving average, and band of 1%) Figures in the parenthesis represents the T statistics testing the difference of the mean buy and sell from the unconditional daily mean. 3 Figures in the parenthesis represents the T statistics testing the difference of the mean buy and sell from zero. ‘*’, ‘**’, ‘***’ denotes 1% and 10% level of significance respectively. 2
The mean buy and sell returns are reported
many earlier studies that found technical
separately in column 3 and 4. The buy
analysis to be useless might have been
returns are all positive with an average one
premature. Overall the results provide
day return of
strong support for technical strategies that we explored.
VI.
Conclusion
The recent studies on predictability of equity returns from the past returns suggest that the conclusion reached by Available online: http://internationaljournalofresearch.org/
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VII.
Economics and Finance Discussion
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