Financial Markets and Trading: An Introduction to Market Microstructure and Trading Strategies

CHAPTER 10

Technical Trading Strategies

Technical analysis (TA) is a field comprising various methods for forecasting the future direction of price. These methods are generally based on analysis of past prices but may also rely on other market data, such as trading volume and volatility (see e.g., Kaufman 2005).¹ As was indicated in Chapter 7, the very premise of TA is in conflict even with the weakest form of the efficient market hypothesis. Therefore, TA is discarded by some influential economists. Yet, TA continues to enjoy popularity not only among practitioners but also within a distinctive part of the academic community (see Park & Irwin 2007 and Menkhoff & Taylor 2007, for recent reviews). What is the reason for “obstinate passion” to TA (as Menhkoff & Taylor put it)?² One explanation was offered by Lo et al. (2000): TA (sometimes referred as charting) fits very well into the visual mode of human cognition. As a result, TA became a very popular tool for pattern recognition prior to the pervasive electronic computing era. Obviously, TA would not have survived if there were no records of success. There have been a number of reports demonstrating that while some TA strategies could be profitable in the past, their performance has been deteriorated in recent years (see, e.g., Kerstner 2003, Aronson 2006, and Neely et al. 2009). In a nutshell, simple TA strategies were profitable in equities and in FX until the 1980s and 1990s, respectively. This conclusion per se does not imply ...