L 4_Currency Forecasting Using Technical Analysis.pdf

7/25/2019 L 4_Currency Forecasting Using Technical Analysis.pdf

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Currency Forecasting Using Technical Analysis

No other forecasting tool has come under more academicscrutiny 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 predictfuture 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 TechnicalAnalysis

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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Swings in exchange rates since 1971 have been greaterthan 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 modelsintrinsic equilibrium is breached


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Technical Analysis has a clear advantage over fundamentalbased 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 ofthe currency but what the market perceives as the Market

Value


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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 technicalanalysis was considerably smaller than for the group usingfundamental analysis

The fundamental group without the aid of technical analysisfollowed extreme contrarian strategies and magnified thevolatility of their returns

By following technical analysis the students in the TechnicalAnalysis group avoided extreme contrarian

Conclusion: Technical based trading strategies inFX proved useful for controlling risk even though itdid not result in improved mean returns.


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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 marketmore volatile and by exacerbating trends in exchange

rates.


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



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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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Considerable Scorn in Academic Circles

Efficient Market Hypothesis (EMH) suggests that technical

analysis is useless

Empirical Evidence suggests the contrary


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Currency Forecasting Using Technical AnalysisDisputing The Efficient Market Hypothesis

Fundamental Forecasts require independent projections ofunderlying economic variables that determine exchangerates

Investor who uses technical analysis finds him/her

trading 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 modelsare designed to capture enough of a market move in

in the hope of catching a sizable profit


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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 thatcarry 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 theprimary wave


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Uptrends indicate advancing prices by successfully higherpeaks

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 isbroken a reversal in market trend is signaled


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To identify and confirm the existence of a trend theTechnical 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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The violation of a valid uptrendline is a signal that the paceof 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 confirmedreversal would be signaled

Markets reverse in many ways but all reversals must be

preceded by the failure of market prices to achievesuccessfully 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



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Currency Forecasting Using Technical AnalysisContinuation Patterns

Price Action that does not end in successfully higher peaksand troughs is viewed as consolidation or a continuous

pattern


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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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Currency Forecasting Using Technical AnalysisCrossover Strategies

Constructed to smooth the erratic movements of dailyexchange 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 strengthand vice versa


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Source: Currency Forecasting: A Guide to Fundamental

and Technical Models of Exchange Rate Determination



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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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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 ExchangeRate Determination


L 4_Currency Forecasting Using Technical Analysis.pdf

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