L 4 Currency Forecasting Using Technical Analysis 4... · Source: Currency Forecasting: A Guide to...

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Currency Forecasting Using Technical Analysis No other forecasting tool has come under more academic scrutiny than technical analysis Technical analysis involves the study of past price behavior The rationale is that if financial asset prices move in trends then trend following trading rules can be used to predict future trends in asset prices

Transcript of L 4 Currency Forecasting Using Technical Analysis 4... · Source: Currency Forecasting: A Guide to...

Page 1: L 4 Currency Forecasting Using Technical Analysis 4... · Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis

• No other forecasting tool has come under more academic scrutiny than technical analysis

• Technical analysis involves the study of past price behavior

• The rationale is that if financial asset prices move in trends then trend following trading rules can be used to predict future trends in asset prices

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical Analysis

• Extremely Popular among traders

• Most fund managers and traders utilize some form of technical analysis, particularly over short time horizons

• Dissatisfaction of currency traders and fund managers over the use of fundamental and economic models of exchange rate determination

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Currency Forecasting Using Technical Analysis

• Swings in exchange rates since 1971 have been greater than expected, frequently overshooting the intrinsic equilibrium levels of fundamental-based models such as PPP, Monetary and Balance of Payments Method of FX rate determination

• When exchange rates overshoot their intrinsic equilibrium level, fundamental based forecasts may prematurely recommend that positions be reversed as the models intrinsic equilibrium is breached

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Currency Forecasting Using Technical Analysis

• Technical Analysis has a clear advantage over fundamental based models when exchange rates swing unexpectedly and in large % terms

• Technical models are designed to keep an investor trading with and not against the trend

• Technical traders are not concerned with the true value of the currency but what the market perceives as the “Market Value”

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Currency Forecasting Using Technical Analysis

• Curcio and Goodhart Study (1993)

The research suggests that to control short-term FX risk many market participants have gravitated from fundamental analysis to technical analysis

Students at the London School of Economics (LSE) were separated into two groups. One group used fundamental analysis and the other used technical analysis. The performance of the two groups were roughly the same.

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Curcio and Goodhart Study

• The standard deviation of the the group using technical analysis was considerably smaller than for the group using fundamental analysis

• The fundamental group without the aid of technical analysis followed extreme contrarian strategies and magnified the volatility of their returns

• By following technical analysis the students in the Technical Analysis group avoided extreme contrarian

• Conclusion: Technical based trading strategies in FX proved useful for controlling risk even though it did not result in improved mean returns.

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Currency Forecasting Using Technical Analysis

• The Group of 30 Study (1985)

Participants were questioned whether they believed the use of technical analysis had a significant impact on the trend of FX rates– 97% responded Yes

The G-30 Study

Respondents believed that the use of technical analysis models had a marked impact by making the FX market more volatile and by exacerbating trends in exchange rates.

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical Analysis

• Allen and Taylor Study (1989)

90% of all FX dealers surveyed in the London FX market used some form of technical analysis to help them formulate their outlook for FX rates over short periods of time, especially for intraday and one-week time horizons.

Over longer periods of time the dealers surveyed used technical analysis to a smaller degree and used fundamental analysis more.

This study substantiates the research hypothesis in last weeks lecture.

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Currency Forecasting Using Technical Analysis

• Considerable Scorn in Academic Circles

• Efficient Market Hypothesis (EMH) suggests that technical analysis is useless

• Empirical Evidence suggests the contrary

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical AnalysisDisputing The Efficient Market Hypothesis

• Fundamental Forecasts require independent projections of underlying economic variables that determine exchange rates

Investor who uses technical analysis finds him/hertrading with the trend and not against it

Trend following models do not attempt to catch the very top or bottom of the market. Instead the models are designed to capture enough of a market move in in the hope of catching a sizable profit

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Currency Forecasting Using Technical Analysis

• All technical analysis models have one thing in common• They seek to identify which direction the broad trend in market

places are heading

• Primary waves are large broad moves in market prices that carry the underlying trend in market prices whether up or down

• Secondary waves are temporary corrections or partial re-tracements of the primary trend over a full cycle

• Trend following models attempt to identify the direction of the primary wave

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Currency Forecasting Using Technical Analysis

• Uptrends indicate advancing prices by successfully higher peaks

• Downtrends will be indicated when declining prices establish successfully lower troughs and when intervening advances fail to rise above preceding peaks

• In a rising market each rally and partial retrenchment will be higher than its predecessor

• When the wave-like series of rising peaks and troughs is broken a reversal in market trend is signaled

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical Analysis

• To identify and confirm the existence of a trend the Technical Analyst will use a trend line under (above) the successive partial retracements of the troughs or peaks.

• The more times the market prices touch the trend line without violating it, the more confident the technical analyst will be that the prevailing trend will continue

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Currency Forecasting Using Technical Analysis

• The violation of a valid uptrendline is a signal that the pace of advance will be altered in the future.

• If there is a failure of market prices to rise above the previous highs and a tendency for intervening price declines to fall below their preceding troughs, a confirmed reversal would be signaled

• Markets reverse in many ways but all reversals must be preceded by the failure of market prices to achieve successfully higher peaks and troughs

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Currency Forecasting Using Technical AnalysisHead and Shoulders Patterns

• One of the most recognizable patterns of market peaks and troughs is the “head and shoulders pattern”

• A head and shoulders reversal pattern is essentially a series of three successive rallies with the second stronger than the first and the third weaker than the second

• Initial indicator of weak demand

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Source: Currency Forecasting: A Guide to Fundamental and

Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical AnalysisContinuation Patterns

• Price Action that does not end in successfully higher peaks and troughs is viewed as consolidation or a continuous pattern

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical AnalysisComputer Generated and Computer Interpreted Models

• Sophisticated techniques subject to less human error

• Filter Rule–Buy recommendations if exchange rates rise x % above their most recent trough and sell recommendations if exchange rates fall x % below their most recent peak

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical AnalysisCrossover Strategies

• Constructed to smooth the erratic movements of daily exchange rates so that the primary trend in exchange rates can be isolated

• An advance of the short-run average above the long-run moving average is seen as an indication of buying strength and vice versa

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Source: Currency Forecasting: A Guide to Fundamental

and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical AnalysisExtrapolation and Lag

• All trend following techniques use extrapolation

• All trend following techniques have a lag effect– Lag effects are not pronounced when FX rate swings are sustained

– Lag effects are pronounced in a trend less environment and whipsaws and false signals will occur

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Currency Forecasting Using Technical Analysis

• Technical models are able to correctly predict trends 50% of the time (Schulmeister, 1987)

• Profits are allowed to ride when the markets are up trended while losses are taken quickly when whipsaws occurred

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Currency Forecasting Using Technical AnalysisMomentum

• Momentum usually confirms the trend

• Rising prices occur with increasing velocity

• With rising momentum the odds are that the trend will continue

• However if prices are rising with decreasing momentum it may be a sign of weakness in a prevailing trend

• Overbought or Oversold conditions

• Useful warning signs

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Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination

By: Michael R. Rosenberg

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Source: Currency Forecasting: A Guide to

Fundamental and Technical Models of Exchange

Rate Determination

By: Michael R. Rosenberg