Brian Leip

PROFITABILITY OF AUTOMATED TECHNICAL TRADING SYSTEMS IN THE FOREIGN EXCHANGE MARKET

College of Business AdministrationFinance Major, CBA Honors ProgramSupervisor: Dr. Pamela Miles Homer

OUTLINE

I. Purpose of the StudyII. IntroductionIII. Background and Literature ReviewIV. MethodologyV. HypothesesVI. Results

PURPOSE OF THE STUDYExamine the profitability of 63

publicly available Technical Trading Systems (TTS)Which systems work the best and why?

Currency pairsTechnical indicatorsExit techniqueComplexity/sophistication

PURPOSE OF THE STUDYExpand the understanding of Technical

AnalysisTechnical analysis - “the study of market action,

primarily through the use of charts, for the purpose of forecasting future price trends” (Murphy, 1999)

TA historically disregarded by academia due to its conflict with the efficient market hypothesis (EMH)

Sparse coverage of TA at the college level

TA is widely used by practitioners creating a large gap between “the classroom” and “the street”

INTRODUCTION – Efficient Market Hypothesis (EMH)

What is the Efficient Market Hypothesis (EMH)?Dominant paradigm in financial theory from

the 60s to the 90s

Markets created by hyper-rational decision makers

No one can beat the market except by luck or by taking on riskTherefore TA and FA should not work

INTRODUCTION – Efficient Market Hypothesis (EMH)Prominent Critics

Warren Buffett - InvestorJohn Maynard Keynes – EconomistRobert Haugen – Professor at UC IrvinePaul McCulley – Managing director at PIMCOThe field of behavioral financeAll practitioners using fundamental and/or

technical analysis

Universities now expanding beyond EMH but still very few classes on Technical AnalysisSkepticism of TA slow to change

INTRODUCTION – Technical AnalysisPurpose of Technical Analysis

To capitalize on market inefficiencies (e.g. trends)

Types of TA MethodsQualitative – Charting (pattern finding)Quantitative – Technical indicators, trading

systemsUsed in this study

INTRODUCTION – Technical AnalysisTenets of Technical Analysis

1. Market action (price and volume data) efficiently summarizes all microeconomic, macroeconomic and behavioral information

2. Prices move in trends

3. History repeats itself

INTRODUCTION – Chart with Technical Indicators

INTRODUCTION – The Foreign Exchange MarketFloating Rate Foreign Exchange Market

Also called forex or FX marketBegan in early 70sAll currencies are quoted in relation to another

EURUSD = Price of the Euro in relation to the US Dollar

To buy one currency you must also sell anotherDaily turnover = 2 trillion USD

Several times greater than all stock exchanges in the world combined

TA used extensively in forex market

INTRODUCTION – The Foreign Exchange Market

Source: Cheung & Chinn (2001)

TA use in the foreign exchange (forex) market Taylor and Allen (1992)

90% of UK forex respondents use some form of TA Cheung & Chinn (2001)

30% of US forex market practitioners would best describe themselves as TA traders

BACKGROUND AND LITERATURE REVIEW

Early Studies – TA in the Stock Market (60s & 70s)Widely cited studies from the 60s find TA to

be unprofitableFama and Blume (1966)Van Horne and Parker (1967, 1968) Jensen and Benington (1970)

Fama declares TA to be a futile undertaking (1970)Note: Fama is the founder of the Efficient Market

Hypothesis

BACKGROUND AND LITERATURE REVIEWEarly Studies – TA in the Forex Market

(60s, 70s & 80s)In contrast, TA studies in FX market generally

found sizable net profitsPoole (1967)Dooley and Shafer (1976)Logue and Sweeney (1977)Logue, Sweeney and Willett (1978)Cornell and Dietrich (1978)Dooley and Shafer (1983)Sweeney (1986)Schulmeister (1987)

Shortcomings in study methodologies

BACKGROUND AND LITERATURE REVIEW

Modern StudiesAddress shortcomings found in early studiesMixed results on profitability

56 of 95 (59%) - positive returns20 of 95 (21%) - negative returns19 of 95 (20%) – mixed results

Source: Park, Irwin (2007)

BACKGROUND AND LITERATURE REVIEWSurvey of literature for TA in forex market

Menkhoff, Taylor (2007)Review of 44 academic studies

ConclusionBeyond question that TA may be used to provide

very high returnsTA is an intrinsic part of the forex marketFor researchers, this means TA must be

understood and integrated into economic reasoning

For practitioners, TA strategies must be constantly evaluated as potentially important tools

METHODOLOGY What makes my study unique?

Number of Technical Trading Systems – 63 To my knowledge, 23 is the max in other

studies Time frame

1975 – 2010 (35 years) Results geared towards finding the best

technical trading systems rather than refuting EMH

METHODOLOGY1. Select target market [forex], vehicles [7 major

currency pairs] and time frame [daily]

2. Gather publicly available trading strategies [63 total]

Common usage Ammermann, Conceicao (2010)

CSULB Finance Professor and CSULB Alum Bollinger (2002) Elder (1993) Katz (2000) Leip (2010)

Systems and indicators I created Murphy (1999) Pruitt, Hill (2003)

METHODOLOGY

3. Program the 63 Strategies into TradeStation

METHODOLOGY

4. Bifurcate the available data and run optimizations on recent ½ (in-sample) to generate optimal inputs for the strategy

63 strategies * 7 currency pairs = 441 optimizations

69,030 average tests * 441 = 30,442,230 total tests

METHODOLOGY

5. Organize the results and apply a scoring metric to all tests

6. Select the top performing test from each of the 441 optimizations. Apply to the older ½ of the data (out-of-sample) and save results

7. Gather the 441 out-of-sample results and analyze

METHODOLOGY TradeStation Software Platform

Gold standard for rule based trading Expensive - $100/month Recipient of numerous awards

HYPOTHESES H1 –Technical Trading Systems will

have out-of-sample excess profits that cannot be accounted for by the bearing of risk

H2 – The more complex Technical Trading Systems will outperform less complex ones

Excess profit test Sharpe Ratio – Calculates excess returns over

the risk free rate

RESULTS Avg. Sharpe Ratio by Strategy

RESULTS Avg Sharpe Ratio by Complexity

(1=simple, 5=complex)

HYPOTHESES – Expected Results H1 – Sharpe ratios indicate that

Technical Trading Systems have out-of-sample excess profits that cannot be accounted for by the bearing of risk

H2 – Sharpe ratios indicate a clear link between excess risk adjusted returns and complexity

APPENDIX - RESULTS Avg. Sharpe Ratio by Currency

APPENDIX - RESULTS Avg. Sharpe Ratio by Technical

Indicator

APPENDIX - RESULTS Avg. Sharpe Ratio by Exit Type

APPENDIX - RESULTS Avg. Sharpe Ratio by Source

QUESTION & ANSWER

Thank you for your time