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book_ii

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Wednesday, January 28, 2004 - 10:34 pm:

This Alchemy May Yield Real Gold - Pro charting study

Technical analysts--the Street's soothsayers--get a vote of confidence from MIT rocket scientists

Technical analysts don't get no respect. Academic economists consider their game--predicting stock prices by studying charts--on a par with examining the entrails of a freshly slaughtered goat. Conventional economic wisdom says that stock prices already reflect all relevant information, so past movements are no clue to future ones. Even if stock prices are a little predictable, say most economists, you won't get anywhere by poring over charts for such technical-analyst arcana as ''rising bottoms,'' ''double tops,'' and ''head-and-shoulders formations.'' Burton G. Malkiel, author of A Random Walk Down Wall Street, writes that ''under scientific scrutiny, chart reading must share a pedestal with alchemy.''

But technical analysts--also known as chartists--may yet get the last laugh. A paper written by three authors from the Massachusetts Institute of Technology, and recently published by the prestigious National Bureau of Economic Research, concludes that ''certain technical patterns do provide incremental information, especially for Nasdaq stocks.'' In language that's bold for academics, the paper goes on to say that ''while this does not necessarily imply that technical analysis can be used to generate 'excess' trading profits, it does raise the possibility that technical analysis can add value to the investment process.''

Technical analysis might actually add value? Predictably, technical analysts are overjoyed by the partial endorsement. ''I'm, like, flabbergasted,'' says Ralph J. Acampora, the director of technical research at Prudential Securities Inc. The chartists are particularly pleased that the project was led by Andrew W. Lo, director of MIT's Laboratory for Financial Engineering, who taught many of the finance rocket scientists now working on Wall Street. Says Acampora: ''This gives the field an awful lot of credibility.''

The paper, by Lo, graduate student Harry Mamaysky, and finance professor Jiang Wang (http://www.nber.org/papers/w7613), is tough slogging unless you happen to be on intimate terms with kernel regression estimators and the Kolmogorov-Smirnov test. But its basic strategy is simple. First, the authors wrote a computer program that automated the process of finding 10 of the chartists' favorite patterns. Then they turned the program loose on daily stock returns for hundreds of companies on the New York Stock Exchange, American Stock Exchange, and Nasdaq from 1962 to 1996. Out of more than 800,000 observations of raw data, the program turned up about 2,500 head-and-shoulders patterns (three peaks, the middle one being the highest), about 2,100 triangle tops (a pattern with progressively lower peaks and rising bottoms), and so on.

STARTLING RESULTS. The next step was to see how stocks performed in the period after a pattern was completed. If technical analysis were hogwash, the authors should have spotted no regularities at all--just random ups and downs.

The results were startling. The most bullish signal, the inverse head-and-shoulders pattern, produced an average 4% increase in the price of a stock on the third day after the pattern's completion. The most bearish signal, broadening bottoms, produced an average 6.2% decrease (charts). The authors also looked at other statistical measures such as standard deviation and skew and found that they also were significantly different from those of a randomly chosen day in the market.

The reason for waiting until the third day after a pattern's completion to peek at the stock performance was that in practice, it sometimes takes a day or so to recognize that a pattern has formed and to act on it. Plus, the authors figured it would be more impressive to skeptics if a stock was still moving as long as three days after a pattern's completion. While the paper reports only the one-day change, Lo says the authors got similarly impressive results when they looked at five- and 10-day returns.

INTUITIVE INPUT. So, is this bankable? The authors don't offer an opinion. The problem is that there's no agreed-upon definition of what it means to ''beat the market,'' because of the trade-off between risks and rewards. If you earn an above-average return, but take on above-average risks in doing so, doubters will argue that your risk-adjusted return was no better than average. For instance, if a chartist-trading strategy were highly correlated with movements in the overall market, it would expose an investor to extra market risk. Rather than get into a protracted debate about what constitutes beating the market, the MIT group decided to focus on what they could clearly prove. The paper demonstrates that technical patterns do contain genuine information about what is going to happen next in the market.

To be sure, real-life technical analysis isn't as pure as the MIT research. Flesh-and-blood chartists operate heavily on intuition. They often don't agree on whether a particular pattern exists or even what it signals if it does exist. They'll frequently walk both sides of the street, predicting that stocks will fall in the short term but rise in the long term, or vice versa, without precisely defining long or short. ''You scratch three technical analysts, you'll get four opinions,'' says Mike Epstein, the Boston-based director of quantitative trading for NDB Capital Markets.

There is, for example, no consensus among technical analysts about where today's gyrating stock market is headed in the coming days. In the middle of the Nasdaq Composite Index's roller-coaster ride on Apr. 4, Acampora said, ''I don't think it's over for the Nasdaq necessarily,'' but added that ''if they can blow out some more of these stocks, you'll get to the capitulation phase,'' in which stocks touch bottom and rebound. Epstein said, ''I'm looking for a trading rally very shortly, maybe even right here,'' but warned that he might well change his mind the next minute.

PROFITABLE PATTERNS. Despite the theatrics surrounding technical analysis, Lo thinks it works because it provides insight into some of the key forces that determine prices, such as the warring forces of fear and greed. Since markets are made up of real people, not economic automatons, psychological concepts used by technical analysts such as ''resistance levels,'' ''support levels,'' ''overbought,'' ''oversold,'' and ''momentum'' can have real meaning. Lo says that technical analysts ''have been doing informally and intuitively what academic economists do''--namely, measuring the forces of supply and demand.

Ultimately, Lo hopes to use computers to detect new patterns that are better indicators of the stock market than the ones handed down from generation to generation of technical analysts. He acknowledges that any pattern will eventually be arbitraged away, but believes that ''the arbitrage itself can create new ones....There might be two heads and three shoulders--some pretty bizarre Quasimodo figures.'' As Lo sees it, the trick is to develop tools that find exploitable patterns before others do.

Lo says he and his co-authors have been approached about commercializing their work, but they aren't looking to go into technical analysis full-time. ''We actually like being academics a lot,'' he says. On the other hand, Lo isn't completely immune to the lure of money. He said he's still curious about whether technical analysis really can beat the market after adjusting for risk--a question that his latest paper doesn't attempt to answer. If he and his colleagues discover that it can, he says, ''We might never publish that paper.'' Now, there's a professor with a good head on his shoulders.

By Peter Coy in New York

"The team believes the string probably contains thousands of galaxies...The string of galaxies itself is thought to be 300 million light years long. A light year is about 9.5 trillion kilometres." - why I dont stress over trading.

i_claudius

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Wednesday, January 28, 2004 - 11:33 pm:

Hi Bookii

Intriguing stuff!

If a whole University department and their presumably state of the art computing can't turn a profit ... what chance do we plebeians on our rusty old PCs have?

Did they publish a rate of return on average capital employed?

I'm prompted to wonder how accurate, current and scientific the statistics are at this site :-

http://www.marketscreen.com/help/chartpatterns/default.asp?Num=152

Also I wonder how long it will be before computers take over all winning trades ... rather like the computers that beat some (but not all) Grand Champions at chess.

Will we soon all need Mensa membership and a bank of high powered computers to make a buck or a quid?

With Best Wishes

Roger (Executor of the Claudius Literary Estate)

QUOTATION :- "Never stop questioning" ... Posted by Bundy in the Options and Derivatives Forum on Friday, 16 January, 2004 - 21:40

scarrie

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Thursday, January 29, 2004 - 07:50 am:

Hi all, Interesting article. I don't think we need to get to worried about being replaced by a computer. For all a human beings flaws for trading, the human is capable of exercising some judgement. Thats where the difference lies.
I allways get a bit of a chuckle when I read about some academic type trying to prove or disprove the worth of TA. The fact is that lots of people make lots of money from it, and that is all that matters. These guys that embark on disproving TA probably think TA doesn't work simply because they are no good at it. Would be a bit like me saying that golf is a difficult game and impossible to learn, but I don't think Tiger Woods would agree.
Cheers
Dave

i_claudius

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Thursday, January 29, 2004 - 08:39 am:

Dave

Your confidence that "lots of people make lots of money" from trading sounds like the infectious confidence of youth ...

Were you a NAB forex trader before your present life?

Let's hope the concept of making lots of money is as infectiously easy as you make it sound ...

My own view is that if you can't measure it then it doesn't exist so computer modelling ought to be possible for any of the "simple trading rules" we often hear expounded.

As for "human judgement" I would think it is as likely cause as many losses as profits ... unless one has an investor/trading psychology that is tried and tested over the long haul ... even the best traders have losing streaks, sometimes of major proportions & often even the best trade against their "rules" ...

Perhaps you are referring to the magic of charts that produces these "lots of people making lots of money" ...

My impression is quite the contrary ... that very few people make "lots of money" using charts

With Best Wishes

Roger (Executor of the Claudius Literary Estate)

QUOTATION :- "Never stop questioning" ... Posted by Bundy in the Options and Derivatives Forum on Friday, 16 January, 2004 - 21:40

deanrosario

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Thursday, January 29, 2004 - 08:49 am:

Hi Roger

From what I can gather, the demise of the NAB FX trading masters was due to:

- lack of money management
- a sense of invincibility
- inadequate checks and balances between the front and back offices
and, possibly,
- fraud (as the traders set up dummy trades amongst themselves to try to delay detection of their original mistakes)

I have yet to hear anyone mention the use of TA was the cause of the AUD 360m loss.

The more I read the stories of successful traders - i.e. people who make money from TRADING and not from software or book sales - the more I realise that, for short term trading at least, money management is the key to successful trading.

Best wishes
Dean

(Message edited by deanrosario on January 29, 2004)

scarrie

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Thursday, January 29, 2004 - 09:04 am:

Hi Claudius,Thanks for that. I haven't been called a youth in a long time.
I should have said that humans are capable of exercising "good" judgement, but did not mean to imply that they necessarily will. I can't state for certainty that lots of people make money from charting I suppose, but during my learning process, I think my results were bad due to an inner belief / doubt that success wasn't possible, but in an attempt to make it so I continued to look for more and more complicated ways of viewing the market. Like wise, I'm certainly no Tiger Woods, however a little practice and a belief that the simple things work best hasn't done my game any harm.
I would be interested to see how this computer modelling actually works. For eg, how do you scan for double tops? Do the tops have to be the exact same price, or is within a couple of cents OK? I think there are some things that computer modelling can't solve. "If you can't measure it than it doesn't exist" would mean that we would have to eliminate the possibility of the existence of God, Santa Claus and the tooth fairy.
Cheers
Dave, the youth, who can feel his hair growing back as we speak

i_claudius

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Thursday, January 29, 2004 - 10:07 am:

Dean

I totally agree with you ... 1000 small losses are much better than 1000 big ones

Re NAB obviously their charts were telling them something they didn't want to know ... and not telling them what they did need to know ...

This may reinforce the point made in Bookii's message that 10 people can look at one chart and find 10 + x answers?

Dave

In non-financial forums I've had many discussions about the measurable evidence for God, Santa Claus and the tooth fairy ... and the younger generation (such as your good-self) have never been able to trace direct evidence of their existence with computer models.

On the other hand the indirect numbers are on the board or able to be estimated for numbers of adherents, presents bought and teeth placed under pillows ... so in that sense ideas are measurable. A simple poll would determine the number of children seeking tooth fairy gifts etc in any one survey period, so these things are statistically measurable if the inclination is there to do it.

Similarly the success rate of chart patterns is quoted (with what accuracy I have no idea) at the site :-

http://www.marketscreen.com/help/chartpatterns/default.asp?Num=152

I would suggest that any trading rules should be statistically measurable for their success outcome ...

I do agree with you ... simpler is often better if only because complex will generally take time ...

Which is where I started ... clever software design should take the time and effort out of complexity and render it simple ...

With Best Wishes

Roger (Executor of the Claudius Literary Estate)

QUOTATION :- "Never stop questioning" ... Posted by Bundy in the Options and Derivatives Forum on Friday, 16 January, 2004 - 21:40

deanrosario

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Thursday, January 29, 2004 - 10:29 am:

Yes, Roger, if there is one IRREFUTABLE fact it is that charts do tell us what IS happening!

The individual then decides what he/she thinks will happen next.

The boys at the NAB heard the charts and chose not to listen. I'd be surprised if this was some new behaviour on their part - more likely, the hierarchy at the NAB were happy for their boys to gamble when the big bucks were rolling in. But, as we at the coalface realise, big returns mean big risk (Finance 101 is obviously not taught at the NAB).

You don't need to be a Master of the Universe to have seen the AUD was bullish post September 2003 against the USD.

However, you do have to be a gambler to take the opposite view to the rest of the market - especially when that market (FX) is the BIGGEST market in the world.

Whilst the NAB may be Australia's biggest company, it is a mere minnow in the world of global FX trading. Taking an opposite view in such a market can be very lucrative but you'll be eaten alive when you are wrong.

Hope your day is going well - just glad CMC allows us to short stocks!

Regards
Dean

fox_terrier

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Thursday, January 29, 2004 - 11:57 am:

Hi Dean,

Still investigating short options.

By CMC do you mean D4Free and CFDs or is there another arm at CMC that allows shorting via some other instrument?

Cheers
fox_terrier

deanrosario

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Thursday, January 29, 2004 - 12:24 pm:

Hi fox_terrier

I can only refer to D4F as CMC from now on - otherwise I'd guilty of "false and misleading" statements.

And, yes, I'm referring to CFDs.

Notwithstanding that jibe, I've got no complaints with their service.

Dean

(Message edited by deanrosario on January 29, 2004)

fox_terrier

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Thursday, January 29, 2004 - 04:33 pm:

Thanks Dean

Must look them up again soon.

Fox_terrier

spider

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Thursday, January 29, 2004 - 11:42 pm:

When I first started reading this thread I was a little apprehensive as I thought that 'people' were starting to work out that TA is a license to print money.

I was a little worried because I really don't want too many people to find out the 'secret'.
Just enough people so that I can have a few friends who I can spend time with during the day while everyone else is off working for 'the man'.

As long as the debate stays on the subject of whether TA works or not , we are safe. That is a good solid debate that people can get there teeth into, and it will distract just about everyone from finding out the real secret.

Unfortunately, I think that scarrie has figured it out.

But that is OK, it's only one. Most people are going to walk straight past it, and not recognize it.

That is why I know that the secret is safe, because it is hidden in plai