web site: www.sta-uk.

org The Journal of the STA

1
Committee member Axel Rudolph recently interviewed Jack Schwager
at the Technical Analysis Trading Forum in Washington DC where he
was presented with the Traders Hall of Fame Award for his
contribution to technical analysis.
While researching his books, Schwager interviewed over 50 of the
worlds most successful hedge fund managers and found a crucial
common thread: there is no place for emotion. Truly great traders
retain their objectivity. Thats what sets them apart from most
investors, he asserts. Some traders will determine beforehand how a
trade should run and will place loss-limiting orders accordingly. Others
will exit, or reduce their exposure if they become unsure about it.
Either way the emotion is stripped out. As long as you are in a
position you cannot think straight, Schwager recalls, as he thinks back
to a time when he ran a profit before giving most of it back again.
Naturally, I wanted most of all to know from him what the winning
methods and common traits of the most successful traders are.
There is no single true path, he declared. The method is the least
important part.
From his roots as a pure fundamentalist Schwager has, over the years,
come to favour the technical approach at least in his own trading arena
futures. But Schwager is ready to admit that both approaches have
the ability to give people an edge.
Many of the Market Wizards he has interviewed have made
tremendous returns relying solely on fundamental analysis. But
Schwager is convinced by hard evidence that pure technical analysis
can consistently yield profits so far in excess of losses that there can
be no question of a statistical fluke. You can make an empirical,
statistical argument that technical analysis works. Most people may
lose using technical analysis but the fact that any of them can get
such an amazing outweighing of gains to losses would argue that
there is something there.
Some hedge funds which consistently make annual returns over 20%
are right less than 50% of the time. Its not a question of the
percentage of times you win. Its a matter of what the expected gain
is compared with the expected loss, he points out. But Schwager
also cites a contrasting example of one of the worlds most successful
S&P stock futures traders, Mark Cook, who has a trade where he will
risk three times as much as he stands to gain. However, on that
particular trade he will win about 85% of the time.
Investors thus need to have some kind of combination of either
being right very often or, on average, to make much more than they
are risking to consistently make money.
To complement a methodology with an edge, investors must also
apply a consistent discipline, says Schwager. Of course, this sounds
much easier than it is, because of the emotions involved in trading.
Schwager believes psychology is a key constituent of successful
investing. Anyone that has ever traded knows that nearly everyone
makes irrational decisions based on emotions such as fear, greed or
hope at some point or other. It is at these times that big losses occur
and investors get wiped out.
In all three books, Schwager interviewed a number of trading
coaches, one of whom is Dr. Ari Kiev, author and expert in trading
psychology. I dont need any more reason to include Dr. Kiev in my
latest book beyond the fact that Steve Cohen, probably one of the
greatest traders that has ever lived, thinks enough of him to have
him on his staff. Thats all the endorsement I need, he declares.
For outstanding investors, says Schwager, failure is not an option and
losses are part of the game. Many of the power traders have indeed
lost all of what they had and actually ended up in debt before
becoming truly successful at trading. Persistence and a sheer
unbreakable conviction that they will succeed is a common thread
among not just great traders but anyone who excels. And just one
other thing you have to like doing it. You have got to be sure
that trading is what you want to do, he warns. Most highly
successful traders are workaholics working 12-14 hour days,
Saturday and Sundays.
The message for aspiring market wizards who have studied
Schwagers thoughts is clear: there is no mystique, no magic formula,
no hidden secrets. Successful traders eat, sleep and dream about
trading. They absolutely thrive on it and enjoy it.
Reproduced by permission of Dow Jones Newswires
www.dowjonesnews.com
COPY DEADLINE FOR THE NEXT ISSUE
SEPTEMBER 2001
PUBLICATION OF THE NEXT ISSUE
OCTOBER 2001
July 2001 ISSUE No. 41
MARKET TECHNICIAN
FOR YOUR DIARY
IN THIS ISSUE
Wednesday 12th September Monthly Meeting
Wednesday 10th October AGM
Wednesday 14th November Monthly Meeting
N.B. The monthly meetings will take place at the Institute of Marine Engineers, 80 Coleman Street,
London EC2 at 6.00 p.m.
Exam Results 2
D. Watts Software review 3
A. Goodacre Evidence on the performance of the
CRISMA trading system in the US and
UK equity markets 4
R. Klink Is the close price really the closing price? 8
Financial Overconfidence In markets 9
Markets Group
D. Watts Bytes and pieces 13
M. Smyrk Book review 13
B. Millard Predicting future price movement 14
WHO TO CONTACT ON YOUR COMMITTEE
CHAIRMAN
Adam Sorab, Deutsche Bank Asset Management,
1 Appold Street, London EC2A 2UU
TREASURER
Vic Woodhouse. Tel: 020-8810 4500
PROGRAMME ORGANISATION
Mark Tennyson dEyncourt. Tel: 020-8995 5998 (eves)
LIBRARY AND LIAISON
Michael Feeny. Tel: 020-7786 1322
The Barbican Library contains our collection. Michael buys
new books for it where appropriate, any suggestions for new
books should be made to him.
EDUCATION
John Cameron. Tel: 01981-510210
Clive Hale. Tel: 01628-471911
George MacLean. Tel: 020-7312 7000
Michael Smyrk. Tel: 01428 643310
EXTERNAL RELATIONS
Axel Rudolph. Tel: 020-7842 9494
IFTA
Anne Whitby. Tel: 020-7636 6533
MARKETING
Simon Warren. Tel: 020-7656 2212
Kevan Conlon. Tel: 020-7329 6333
Tom Nagle. Tel: 020-7337 3787
MEMBERSHIP
Simon Warren. Tel: 020-7656 2212
Gerry Celaya. Tel: 020-7730 5316
Barry Tarr. Tel: 020-7522 3626
REGIONAL CHAPTERS
Robert Newgrosh. Tel: 0161-428 1069
Murray Gunn. Tel: 0131-245 7885
SECRETARY
Mark Tennyson dEyncourt. Tel: 020-8995 5998 (eves)
STA JOURNAL
Editor, Deborah Owen, 108 Barnsbury Road, London N1 0ES
Please keep the articles coming in the success of the Journal
depends on its authors, and we would like to thank all those
who have supported us with their high standard of work. The
aim is to make the Journal a valuable showcase for members
research as well as to inform and entertain readers.
The Society is not responsible for any material published in
The Market Technician and publication of any material or
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conduct investment business and does not provide
investment advice or recommendations.
Articles are published without responsibility on the part of the
Society, the editor or authors for loss occasioned by any
person acting or refraining from action as a result of any view
expressed therein.
STA DIPLOMA APRIL 2001
PASS LIST
L. Anastassiou F. Lien
M. Chesterton V. Mahajan
E. Chu M. Randall
D. Cunnington J. Richie
P. Day M. Schmidt
B. Jamieson M. Shannon
P. Kedia M. Sheridan
R. Khandelwal M. Wahl
R. Klingenschmidt P. Wong
M. Knowles
DITA II CANDIDATES
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MARKET TECHNICIAN Issue 41 July 2001
Networking Exam Results
ANY QUERIES
For any queries about joining the Society, attending
one of the STA courses on technical analysis or
taking the diploma examination, please contact:
STA Administration Services
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P.O. Box 2, Skipton BD23 6YH.
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please contact:
Deborah Owen
108 Barnsbury Road, London N1 OES.
Tel/Fax: 020-7278 7220
Software available for sale as a result of a prize draw win.
Software is unused. Nirvanas Omnitrader end of day
stocks edition: high end automation of technical analysis
with 120 built-in trading systems. Hot Trader Gann Swing
Charting Program. 200 per package/ 350 for both inc.
P&P (mainland UK). A 20 reduction per package for
people who attend the monthly meetings, and who
therefore dont
require P&P.
Contact: Mr Rahul Mahajan MSc MBA MSTA
E-mail: r.mahajan@btinternet.com
Issue 41 July 2001 MARKET TECHNICIAN
3
TradingExpert 6 is the latest offering from the AIQ people. AIQ
(which stands for Artificial Intelligence Quotient) refers to the
Expert System that is at the heart of this suite of programs, but it
is also much more, with state of the art market charting and analysis
being incorporated. The program modules integrate well together,
forming a coherent complementary suite of programs that few others
can match.
Installation of the suite of programs is straightforward, both with an
instructional video provided to ease this process and the programs
initial operation. After installation, the programs are found via a tool
bar on the desktop, which allows you to access the specific module
that you require. What is impressive is the range and depth of the
applications on offer. These comprise the charting package with the
associated technical indicators and expert system. There is a data
manager and communication interface. An excellent addition is
Matchmaker a program to correlate groups of stocks and sort
them into groups or sectors. Also significant is the real time quote
monitor, a system and scanning writing programme called the
Expert-Design Studio, and a Portfolio Manager. In short, you have
a complete suite of programs to suit all your analysis or trading needs.
At the heart of this package is the technical charting package with an
array of indicators and the Expert System. The security chart is displayed
with a list of indicators to the right. With one click any of these can be
added to the chart. The indicator window also incorporates the Expert
Rating together with the indicators that form the basis of the system.
The Expert System gives a consensus rating of the technical indicators,
providing a prediction of the likely future price movement of the
security, with a rating from 0 to 100. Further information is provided by
clicking upon the ER icon and up pops a box showing the reasoning
for the expert rating shown. Does the Expert system perform? Overall I
found the expert rating useful with some correlation to future price
movement, but this is subjective judgement.
In the Charting module, I particularly liked the one click insertion of
technical indicators and moving averages into a chart, also the ability
to change the defaults by clicking on the indicator displayed. Bar, line
and candlestick charts can quickly be displayed via the top toolbar,
but point and figure charts were disappointing, being too small to be
analysed in the indicator window. Another column of icons provides
the drawing and retracement tools, all being very easy to place and
change on the chart.
The suite also provides a Data Manager, with an extensive collection
of pre-defined databases for the SP500, Nasdaq, FTSE100 stocks etc.
The US/UK stocks with their tickers and exchanges are defined. All
data is kept in the proprietary AIQ format, at which point I wished
the package could read the standard Metastock/Computrac data
format, as yet another database had to be set-up and maintained.
However the Data Manager and communications program makes
this easy.
The communications program allows you to download data from the
Mytrack servers, which I found fast and easy to use. The
communication package loads data once you are connected to the
Internet, making an Internet connection essential. The Mytrack servers
also provide real-time data via the Quotes and Alerts modules, so
once online both historical and real-time data are available.
One excellent feature is that once a download is completed, the AIQ
package also computes a set of reports for the most common
technical criteria reports, Relative Strength, new highs or lows,
breakouts, high volume days, and P&F breakouts. These are instantly
available, making processing thousands of stocks a breeze, and can
be immediately printed or stored for later analysis.
The reports are available via the reports module, their breadth being
the most extensive I have ever seen. Daily, weekly, sector, group and
technical stock reports are all available, allowing a top down
approach to stock selection to be developed, via a market, then
sector, then stock. Furthermore, by clicking upon any security in the
report module, up comes the chart for analysis. It is this integration
that AIQ provides that allows real productivity gains to be made
when analysing thousands of stocks and, importantly, not missing
key technical events.
The AIQ package scores again with its Expert Design Studio; here
you can produce your own reports or back test a system. The
program allows you to produce your own system, then scan for
when those system criteria are met. Also unique is the ability to
reference and hence back-test the Expert System in your analysis. An
extensive list of pre-programmed studies are available should you not
wish to program your own. Clearly AIQ have not left anything out of
this suite of packages, and even more programs are included, such as
the account manager and the fundamental database module.
So having found your stock you want to monitor it real-time? With
one click the real-time quote monitor, gives you a table of quotes
with both intra-day and historical charts. I did find one annoyance, in
that this did not work for a historical chart of a UK stock, the
designation for London having to be changed each time, from
-L to @L, whereas with one click US stock charts were instantly
available. For real-time UK charts this was not a problem, with
charts down to one minute being available in the charting module.
How did the feed perform? Using a standard 56k modem, I found
that the real-time data feed performed well with timely data, but a
good Internet service provider is critical.
Matchmaker is a real gem in the program suite. Here, via
correlation analysis, it is possible to generate groups and sectors and
look for leaders or laggards within a particular correlated group. AIQ
uses a correlation approach to defining sectors and the performance
of a stock within a sector. Then a variety of groups can be
produced; for example, following the Wychoff approach, an index
surrogate is possible. The Index surrogate generated could perhaps
be of the top ten FTSE100 stocks by capitalisation as a leading
indicator? Or you can generate a surrogate using spreads between
correlated stocks, buying or selling the spread once it is overbought
or oversold.
Overall I liked this package for its ease of use and integration with
the Internet. It offers a number of often excluded essential facilities
for the equity analyst or stock trader. The extensive reports are a real
boon for the analyst handling large numbers of stocks. The reports
and data handling allow fast processing, while the expert system is a
bonus for the less experienced. Further details can be found via the
AIQ website at www.aiq.com.
Software review AIQ TradingExpert 6 Review
By David Watts
FTSE100 INDEX
4
MARKET TECHNICIAN Issue 41 July 2001
The work reported here was undertaken jointly (but at different
times) with three researchers while they were students on the MSc
in Investment Analysis programme at Stirling University. I would
like to acknowledge the considerable contributions made by
Jacqueline Bosher, Andrew Dove and Tessa Kohn-Speyer.
One of the problems with technical analysis is that it is difficult to
apply academic rigour to what is essentially an art form. As a result,
academics have tended to focus on the more objective processes in
technical analysis, and typically, relatively simple trading rules such as
filter rules, relative strength and moving averages have been tested.
In many ways, this is somewhat unfair to technical analysts since
they often implore the use of several indicators to confirm trading
decisions. One unusual feature of the CRISMA (Cumulative volume,
RelatIve Strength, Moving Average) trading system is that it is based
on a multi-component trading rule that is objective and can therefore
be subjected to rigorous analysis and testing. Another is that details
of the system were first published more than ten years ago (Pruitt
and White, 1988, 1989 and Pruitt, Tse and White, 1992). The system
was shown to work very successfully in the US equity market. It was
tested out-of-sample, adjusted for risk, and with due allowance for
transaction costs and yet still provided statistically and economically
significant excess returns. Based on data for the period 1976 to 1985
the system predicted annualised excess returns of between 6.1% and
35.6% (depending on the level of transaction costs) and similar
excess returns continued for the 1986 to 1990 period. The CRISMA
system was also applied to identify the purchase of call options on
the underlying shares (Pruitt and White, 1989). Even in the presence
of maximum retail costs, the average round-trip profit was 12.1%
with an average holding period for each option contract of
approximately 25 days.
In an efficient market, technical trading systems such as CRISMA
should not be able to produce abnormal returns or beat the market,
once adjusted for risk and transaction costs. That CRISMA did
produce abnormal returns, not only during the initial test period, but
using out-of-sample data after the initial publication of CRISMAs
success, led Pruitt and White to conclude that staggering market
inefficiencies existed.
Whats more, the system is used by one of its originators to run real
money in a professional portfolio. The systems impressive
credentials attracted our attention and so, some time ago, we set out
to investigate whether CRISMA continues to work in the US and
whether it works in the UK market.
The rest of the paper is organised as follows. First, details of the
CRISMA system are described, followed by the data and methods we
used in back-testing the system. Results from applying the system in
the US market are presented and compared with Pruitt et als results,
as well as an analysis of the contributions of the system components.
A brief summary of the results for the UK market is provided,
including application of the system to option purchases, before some
final concluding remarks on the usefulness of the system.
The CRISMA trading system
The CRISMA trading rule operates a filter system for selecting equity
targets. The first three filters attempt to triple confirm upward
momentum, and use the 50 and 200-day price moving averages,
relative strength and volume as indicators. These filters must be
satisfied on the same day.
The moving average filter is satisfied when a stocks 50-day price
moving average intersects the 200-day price moving average from
below, when the slope of the latter is zero or positive. This can only
occur when the price of the stock is increasing relative to previous
periods. This golden cross is used to indicate the start of an upward
trend, which is expected to continue upwards.
The relative strength filter is satisfied when, over the previous four
weeks, relative strength has increased or remained unchanged. This
filter ensures that the relative performance of the stock is at least
equal to the relative performance of the market as a whole in the
previous four weeks.
Cumulative volume (also called on-balance volume by some users,
for example in Bloombergs) is defined as the cumulative sum of the
volume on days on which the price increases, minus the volume on
days on which the price falls. The cumulative volume filter is satisfied
if its level has increased over the past four weeks, suggesting that
there is increasing demand for the stock.
Once the first three filters are satisfied, the stock is purchased when
it reaches 110% of the intersection point of the 50 and 200 day
price moving averages. This final penetration filter attempts to
reduce the likelihood of whipsaws, the inadvertent issue of false
signals; it does not have to be satisfied on the same date as the first
three filters.
Stocks are sold when either the price rises to 120% of the moving
average crossover point or when it falls below the 200 day price
moving average. There are 3 exceptions to the trading system
mechanics as detailed below:
1. If the price of the stock does not reach the 110% level of the
intersection between the 50 and 200 day moving averages within
5 weeks of the first three filters being satisfied, it is not purchased,
2. If the stock price is already above the 110% filter when the first
3 filters are satisfied, it is not purchased until it has fallen below
this level, and
3. If the stock price is already above the 110% level, when the first
three filters are satisfied and reaches 120% of the intersection
point of the 50 and 200 day price moving averages without
falling below the 110% level, it is not purchased.
METHODS
Pruitt and White (1988) used the Daily Graphs series published
weekly by William ONeil and Company, Inc. to aid in the
identification of trades. Figure 1 re-creates the graphical selection
process for the CRISMA trading rule, using data from the current
study for American Airlines.
Identifying trades in this manner involves elements of subjectivity and
is time consuming, so a more efficient and accurate approach, using
a spreadsheet macro, was adopted. The macro imports pre-tidied
price and volume data for each company into a template containing
the formulae for the moving averages, relative strength and
cumulative volume measures. It then searches for days on which
CRISMAs three initial filters are satisfied and calculates the 110%
and 120% price levels. The dates of the purchase and subsequent
sale of the stock are then identified and, providing no exceptions to
the rule have been breached, the dates and prices are subsequently
copied to a results table.
A random sample of 333 companies from the S&P 500 was selected in
June 1997 with the requirement that a minimum of 4 years of volume
data could be obtained between January 1987 and June 1996. 11
companies were excluded due to insufficient available data giving a
final sample of 322. This sample selection process implies a degree of
survivorship bias (Kan and Kirikos, 1995) which is discussed later. The
prices obtained from Datastream were daily mid-market closing prices,
pre-adjusted for bonus and rights issues. The benchmark index used
for the return calculations was the S&P 500 Index.
Evidence on the performance of the CRISMA
trading system in the US and UK equity markets
By Alan Goodacre
Issue 41 July 2001 MARKET TECHNICIAN
5
To assess how successful CRISMA might have been, several questions
were considered.
On average:
Are the trades profitable?
Do the trades beat a market benchmark?
Do the trades beat a risk-adjusted benchmark?
Is the proportion of successful trades greater than the 50%
expected by chance?
How are the answers affected by transaction costs?
All of the above questions have to be considered in the context that,
effectively, we have taken a sample from all of the possible trades
(over all companies and all time). Sampling theory suggests that
positive answers to the above performance questions can be
achieved by chance, (i.e. solely as a result of the sampling process),
so the likelihood of the observations being chance events needs to be
assessed. This is achieved by carrying out hypothesis tests on the
results to identify those that are unlikely to be chance events
(described as being statistically significant and noted by an asterisk
in the Tables). This provides some confidence that any success might
be due to the CRISMA system rather than luck.
RESULTS
Results in the US market for the period 1 January 1988 through
30 June 1996
From the 322 companies included in the sample, over the 8
1
/2 year
test period the CRISMA trading system identified 328 trades in 208
companies whose stocks were assumed held for a total of 14,424
security-days (approximately 2% of the total security-days). This
gives an average annual total of 1,697 security-days which implies a
portfolio of approximately 6.8 stocks, on average. The mean and
median holding periods were 44 and 31 days respectively, with a
maximum holding period of 374 days and a minimum of 1 day.
Table 1 presents a summary of the raw CRISMA generated profits.
Assuming zero transaction costs, the CRISMA trading system would
have been profitable with a mean and median profit per trade of
3.1% and 8.9% respectively. After allowing for round-trip transaction
costs of up to 2% the system was still profitable (all returns are
statistically significantly at 5% or less). The final column of the table
shows arithmetically annualised mean returns. These are calculated
by working out the average (mean) return per day across all of the
328 trades and multiplying by 250 (the approximate number of
potential trading days in a year). These annualised returns ranged
from 17.6% to 6.2% depending on the level of transaction costs
assumed. Thus, the system would have been profitable over the
period, even allowing for transaction costs of up to 2%.
However, a more important question is whether the system adds
value. Does it achieve better performance than a buy-and-hold
policy? To test this, the return on the market (S&P500) was deducted
from the return obtained for each day a stock was held to give a
return in excess of the market benchmark. Again, this was averaged
over all the days stocks were held and then annualised; the results
are in column 3 of Table 2.
A further question of importance is whether the system returns
compensate for the risks taken. Traditional finance theory suggests
that the only risk element that should be rewarded is systematic (or
beta) risk, since all stock-specific risk can be eliminated by holding a
well-diversified portfolio. Of particular importance here is that, in a
rising market, high beta stocks should out-perform the market.
Therefore, column 4 of Table 2 reports the results from using the so-
called market model to allow for the effects of each individual stocks
beta risk (consistent with Pruitt et als testing of the system). However,
it is worth noting that this model is potentially biased against the
trading system. A momentum-based system, such as CRISMA, seeks
to identify relatively good performance by a security in the
expectation that such performance will continue. The market model
will have some recent good performance built into the expectations,
for example, via a positive alpha (the mean value for alpha in the
current study was 8.4%, on an annualised basis). The market-adjusted
return does not suffer from this bias, but unfortunately neither does it
account for the relative riskiness of the stocks held.
The nature of the CRISMA system is that for each trade it seeks to
capture a profit of, or limit the loss to, approximately 9% (i.e.
10/110%). This is quite clearly illustrated in the histogram of
unadjusted returns in Figure 2. If, on balance, a higher proportion of
profitable trades is identified then the system will be successful. Thus, a
key measure of success is the proportion of trades that are profitable.
The lower half of Table 2 reports the proportion of profitable trades for
each of the benchmarks and transaction cost levels.
Transaction
Profit per trade (%)
Annualised
Costs Mean Median mean profit (%)
0.0% 3.1* 8.9 17.6*
0.5% 2.6* 8.4 14.8*
1.0% 2.1* 7.9 11.9*
2.0% 1.1* 6.9 6.2*
Table 1: Unadjusted Profits for CRISMA trading system Jan 88 to
June 96
Figure 2: Histogram of raw CRISMA returns Jan 88 to June 96
Figure 1: The CRISMA trading system applied to American Airlines
1. The 50-day moving average crosses the 200-day moving
average from below at a price of $60.9 on 13 December
1991. The slope of the 200-day moving average over the
previous four weeks is positive. The 110% and 120% price
levels are $67.0 and $73.1 respectively.
2. The relative strength and cumulative volume graphs are
positively sloped over the previous four weeks.
3. The 110% buy level is reached on 23 December and a buy
at $68.9 is indicated.
4. The 120% sell level of $73.1 is exceeded on 7 January 1992,
when a sell price of $75.0 is indicated.
5. Thus this trade achieves a raw profit (unadjusted for
dividends, transaction costs and risk) of 8.9% over a period
of 9 trading days when the market (S&P 500) rose by 5.2%.
6
MARKET TECHNICIAN Issue 41 July 2001
As can be seen from Table 2, adjusting for market movements and
risk significantly decreases the returns predicted by CRISMA.
Assuming zero transaction costs, the annualised mean excess return
is just 0.1% when compare with the market benchmark. Taking beta
risk into account further reduces the return to -6.8%. For non-zero
levels of transaction costs, the excess returns are negative for both
benchmarks, statistically significant for transaction costs of 2%
(market) and 0.5% and above (risk-adjusted).
An alternative way of assessing the success of CRISMA is to test
the proportion of recommended trades that were profitable (lower
half, Table 2). Generally, more than the 0.5 expected by chance
were identified, statistically greater than 0.5 for unadjusted returns
and also at low transaction cost levels for market-benchmark
returns. Thus, there is some evidence of success at predicting
profitable trades but no evidence of the system generating excess
returns.
It is not easy to identify the likely effect of the element of survivorship
bias implicit in the sample selection procedure. Companies that have
been forced out of the S&P 500 through failure and those that have
been acquired, or merged, will be under-represented in the sample;
i.e. good performance companies are likely to be over-represented,
suggesting a possible positive bias in reported returns. Kan and Kirikos
(1995) report a significant overstatement of the performance of a
momentum based trading strategy resulting from a similar selection
process in the Toronto stock exchange. If there is a positive bias in the
current study, this would imply that the CRISMA system performs
even less well than reported here.
In summary, back-testing the CRISMA system in the US market over
the 1988-96 period produces disappointing results. While the system
identifies profitable trades, even in the absence of transaction costs it
does not add value by providing significant returns in excess of a
buy-and-hold strategy. Once transaction costs are incorporated, the
system actually under-performs a buy-and-hold strategy.
Comparison with Pruitt et al studies
While much of the current study period is subsequent to the Pruitt et
al test periods, there is an overlapping period of 2
1
/2 years. This
allows a direct comparison between the graphical approach of Pruitt
et al and the spreadsheet-automated approach adopted here. Results
from this comparison and a summary of the original Pruitt et al
studies are presented in Table 3 (nr means that the measures were
not reported in the Pruitt papers).
The contrast between the positive excess returns in both Pruitt
studies and the negative returns here is very striking; similarly, there
is a marked difference between the proportions of profitable trades.
Particularly disconcerting are the differences in the results over the
identical overlap period June 88 through December 1990. Our
method finds more trades, resulting in more days held but identifies
less than 0.5 profitable trades. This leads to significant negative
excess returns of 16.5% against the market benchmark and 18.3%
on a risk-adjusted basis. By contrast, Pruitt et al found 0.76 of
profitable trades (at zero transaction costs) giving a significant
positive annualised excess return of 29.1% on a risk-adjusted basis.
Possible explanations for this different performance were investigated
relating to three areas: sample selection, method of application and
returns measurement. For this exercise zero transaction costs are
assumed throughout.
Pruitt et al. included all stocks jointly included in the CRSP daily data
tapes and the Daily Graphs series in contrast to our random selection
of approximately two-thirds of the S&P 500. One possible
explanation might be that these two samples have different
distributions of company size. We found evidence in the current
study that CRISMA performed better on the largest companies in the
sample, so if the Pruitt sample was biased towards larger companies
this might have contributed to the observed differences.
Application of the CRISMA system using the objective spreadsheet
approach rules out any subjective input to trade identification. For
example, one issue concerns the potential false identification of a
sell signal when a stock price falls when it goes ex-dividend; such
false signals could be avoided in the graph-based approach by
subjective intervention. This issue might have a negative impact on
performance in our computer-based approach through the induced
sale of profitable trades before the profit was achieved or through
the sale of loss-making trades at a lower price. The effect of this was
tested by re-running the full sample through the system with trades
identified on the basis of a smoothed returns price index for each
stock. This index adds back the dividend amount to the price series
thus avoiding a step-down effect on the ex-dividend day and is
available in the Datastream database. The results from this approach
indicate that excess returns were slightly improved to +1.0%
(market) -4.2% (risk-adjusted). Thus, a subjective input to trade
identification of this nature might have improved the Pruitt results
slightly. Pruitt et al. did not define the specific measure of relative
strength that they used, so the sensitivity of the current results to an
alternative definition of relative strength was tested. A larger number
of trades (394) was identified but the effect on returns was quite
small and negative (e.g. excess returns were -0.9% against the
market benchmark).
Perseverance is less of a difficulty in our objective computer-based
identification of trades. The mean and maximum stock holding
Return in excess of
Transaction Unadjusted Market Risk-adjusted
costs return benchmark benchmark
Annualised mean excess return (%)
0.0% 17.6* 0.1 -6.8
0.5% 14.8* -2.8 -9.6*
1.0% 11.9* -5.6 -12.5*
2.0% 6.2* -11.3* -18.2*
Proportion of trades profitable
0.0% 0.61* 0.56* 0.52
0.5% 0.61* 0.55* 0.51
1.0% 0.61* 0.53 0.50
2.0% 0.60* 0.51 0.47
Table 2: Tests of CRISMA trading system performance Jan 88 to
June 96
Return in excess of
Study
Time No of Days Trans Market Risk-adj
period trades held costs (%) benchmark benchmark
Annualised mean excess return (%)
Current 01/88-06/96 328 14424 0 0.1 -6.8
2 -11.3* -18.2*
Current 06/88-12/90 81 3084 0 -16.5* -18.3*
2 -29.6* -31.4*
Pruitt (1992) 06/88-12/90 68 1718 0 nr 29.1*
2 nr 9.3
Pruitt (1992) 01/86-12/90 148 3477 0 nr 26.5*
2 nr 5.2
Pruitt (1988) 01/76-12/85 204 4970 0 28.5* 27.0
2 13.1* 11.6
Proportion of trades profitable
Current 01/88-06/96 328 14424 0 0.56* 0.52
2 0.51 0.47
Current 06/88-12/90 81 3084 0 0.44* 0.43*
2 0.41* 0.40*
Pruitt (1992) 06/88-12/90 68 1718 0 nr 0.76*
2 nr 0.66*
Pruitt (1992) 01/86-12/90 148 3477 0 nr 0.75*
2 nr 0.64*
Pruitt (1988) 01/76-12/85 204 4970 0 0.73* 0.71*
2 0.66* 0.61*
Table 3: Comparison with original Pruitt et al results
Issue 41 July 2001 MARKET TECHNICIAN
7
periods in our study were 44 and 374 days respectively compared
with 24 and 102 in the later Pruitt study. We had 17 trades with
long holding periods (i.e. longer than their maximum period). The
total number of security-days for these trades was 3,254, which
represented 23% of the overall total of security-days, so it is possible
that these trades could significantly influence the overall picture.
Whilst the unadjusted returns for the long trades showed that they
were profitable, on average they achieved lower annualised returns
(10.8%) than the remaining normal holding period trades (19.6%).
However, the removal of long trades would leave small (but
insignificant) positive excess returns of +0.7% (market) or slightly less
negative returns of -5.9% (risk-adjusted).
Overall, the fundamental picture remains unchanged. CRISMA fails to
identify trades that give significant positive returns when adjusted for
market movements and risk, even in the absence of transaction costs.
Importance of the individual components of the
CRISMA trading rule
A weakness of the original Pruitt study is that it did not fully disclose
how the CRISMA system was developed; for example, the rationale
for the specific choices of moving average lengths, filter sizes, relative
strength periods and so on. The papers compensating strengths are
that the returns were adjusted for risk, and testing (certainly in the
second paper) was fully out-of-sample and even subsequent to the
market having knowledge of the system. Ultimately, the continued
success of the system itself can be argued to be sufficient justification.
However, the current study provides an opportunity to investigate the
relative importance of the different components of the system. First,
we identify all potential trades that meet the basic moving average
golden cross component. Then, we observe the proportion of such
trades that are eliminated as a result of the three exceptions to the
systems mechanics (e.g. the price does not rise to the purchase point
within five weeks of the moving average crossover). Last, we identify
the proportion of the remaining trades that are ruled out by the
relative strength (RS) and cumulative volume (CVOL) components
and measure the returns which these excluded trades would have
generated. A number of interesting observations can be made.
First, the number of potential trades eliminated as a result of the
exceptions to the systems mechanics is quite large, representing over
50% of the potential trades, indicating that these exceptions are not
quite as rare as suggested in Pruitt et al. (end note 4, 1988).
Second, the proportion of trades that are excluded because of the
failure of the trades to meet the relative strength and cumulative
volume components of the system is fairly small. The RS rule
excludes approximately 15%, and the CVOL rule approximately 26%
of potential trades that meet the basic golden cross condition;
jointly, these two rules exclude approximately 31% of potential
trades. Third, and more important, the profitability of these excluded
trades is positive and actually superior to the trades that are included!
Overall, the effect of excluding trades because they failed to meet
either the RS or CVOL conditions is to reduce the annualised excess
return by 1.2% against the market benchmark. Thus, the benefits of
the multi-component nature of the CRISMA system over a simple
moving average rule are not proven. The proportion of trades that
fail the extra two conditions is relatively small, and the exclusion of
the trades actually reduces the profitability of the system.
Results in the UK market for the period 1 January
1988 through 30 June 1996
Applying the CRISMA system to a sample of 254 FTSE 350 index
constituents produced very similar results to those presented above
for the US market.
It identified 176 trades in 113 companies whose stocks were
assumed held for a total of 7,067 security-days. The mean and
median holding periods were 40 and 32 days respectively, with a
maximum holding period of 152 days and a minimum of 2 days.
Assuming zero transaction costs the CRISMA trading system would
have been significantly profitable with a mean profit per trade of
3.1% and median profit per trade of 7.9%. After allowing for round-
trip transaction costs of up to 2% the system was still profitable,
though not significantly so at the 2% level of costs. Arithmetically
annualised returns (based on a 250 business day year) ranged from
19.3% to 6.9% depending on the level of transaction costs assumed;
for comparison, the mean annual return on the FTSE All Share Index
over the same time period was 14.0%.
Assuming zero transaction costs, annualised excess returns of 2.2%
(market) and -2.9% (risk-adjusted) were observed. For non-zero
levels of transaction costs the excess returns were negative for both
market and risk-adjusted benchmarks (statistically significant for 2%
and 1% transaction costs, respectively). For unadjusted returns, the
proportion of profitable trades was 0.60 for all four transaction cost
levels. For market benchmark returns, the proportions of profitable
trades were 0.57, 0.56, 0.54 and 0.51 for transaction costs of 0%,
0.5%, 1% and 2% respectively, statistically significantly greater than
0.50 for the two lower cost levels. For risk adjusted returns only 0.51
of trades were profitable at zero transaction costs, but less than 0.5
for the other three levels of costs.
Thus, for trades based on UK equity securities, the results are
similarly disappointing to those observed in the US market.
CRISMA applied to UK exchange traded options
Pruitt and White (1989) argued that few market traders actually
purchase equity securities when applying strategies similar to the
CRISMA system. Rather, they seek the higher leverage and profit
potential represented by exchange-traded options. Consideration of
the performance of such an option strategy was assessed for the UK
market, but was limited by the relatively small number of options
traded at LIFFE. Only 64 trades from the original 176 could be tested
because either there were no options listed on the particular
securities or there were no in-the-money call options available at the
time of the recommendation.
The mean holding period for options was 41 days with maximum
and minimum holding periods of 116 and 5 days. Assuming zero
transaction costs, the mean return per round-trip option trade was
27.7% with 61% of all trades profitable (statistically greater than
0.50). Even in the presence of maximum retail costs (estimated at
approximately 50 per contract, or 11.5% of the mean contract
price), the CRISMA system generated a mean return of 10.2% per
option trade, although with only 55% of trades profitable (not
statistically significantly greater than 0.50). Nevertheless, the
CRISMA system does appear to be able to produce high returns
when used to select options, since a mean return of 10.2% in the
presence of maximum retail transaction costs for an average holding
period of 41 days could not be considered undesirable. The returns
to CRISMA-generated option trades are very similar to those
reported by Pruitt and White (1989, 1992) but the US mean holding
period per trade of 25 days is shorter. The proportion of profitable
trades for the UK is lower than the 68% (64% for maximum retail
costs) reported by Pruitt and White (1992) for the 1986-1990 period.
One important feature of the option-based strategy is that, as with
equities, success depends on achieving a larger proportion of
profitable than unprofitable trades. However, the balance is between
positive and negative returns of about 75% rather than the 9% for
equities. In other words it is a much riskier strategy, so much higher
returns are needed to justify the additional risk.
CONCLUSIONS
The present study back-tested a spreadsheet-based version of the
CRISMA trading system in both the US and the UK markets over the
period 1988 to 1996. In general, the results were somewhat
disappointing. Whilst trades were profitable, on average, once these
were adjusted for market movements and risk they ceased to be so
and transaction costs merely served to worsen the negative excess
returns. The leverage attribute of exchange-traded options tested for
the UK market improved the picture and trades were profitable, on
average, after due allowance for maximum retail transaction costs.
However, this needs to be balanced against the increased risk of
adopting the option strategy.
continues on page 8
8
MARKET TECHNICIAN Issue 41 July 2001
Nothing is more critical to technical analysts in their trading than
accurate price information. Inaccurate historical data can result in
invalid back testing results, leading to the development and
implementation of faulty trading systems. Building a solid and
profitable trading system is hard enough for most of us without this
handicap!
One of the underlying themes in the determination of data quality is
whether the quality issues are ones of system error or by way of
definition. As we will see, there are many and varied ways of
calculating a close price. All methods are valid and their accuracy
may depend on the end users perspective and intended use of the
data.
Whilst I will be primarily focusing on technical analysis in this article,
the effects of data quality extend deep into the finance industry. For
example, Portfolio Valuations, Indexing and Benchmarking rely
heavily on accurate and consistent close prices.
Close prices provide a great starting point in terms of reviewing data
quality issues and consistency questions. As a provider of financial
data globally, we are constantly challenged with the different
variations on close prices defined by global stock exchanges. These
include terms such as end-of-day, last traded, indicative price,
derived price and settlement price. In an attempt to better define
and document the processes used by global exchanges to derive their
close processes, the Financial Information Services Division (FISD) of
the Software and Information Industry Association has weighed in
with their Closing Price Project. For more details on the project, visit
http://www.fisd.net/price
The purpose of this project is to gain transparency and full disclosure
of how close prices are created and calculated by equity exchanges
and processed and displayed by end-of-day price vendors globally.
The focus of this project is not one of dictating the method of
calculation by each exchange and vendor, rather, to define and
document their process so that users of the data will be better able
to understand the origins of the data they are dealing with and any
associated derivations, modifications or assumptions applied to the
same. The team is currently in the process of surveying each
exchange and data vendor to determine this information.
In terms of the exchanges we deal with globally today, many have
published end-of-day price files available for the data vendor
redistribution. These files include, at minimum, Open, High, Low,
Close and Volume values. Some examples of these exchanges include
Australia (www.asx.com.au), New York Stock Exchange
(www.nysedata.com) and Singapore (www.ses.com.sg). By publishing
their own, defined files daily, data consistency levels across data
vendors is high.
Other exchanges, including the London Stock Exchange
(www.londonstockexchange.com) supply data vendors with a real
time data feed. The data vendors then on-process this real time feed
to strip an end-of-day file to supply to end users. This can lead to
differing end-of-day prices being distributed by each data vendor
depending on the methodology used to strip the data from the feed.
For example, how does a vendor define the Open price? The first
trade, or by the definition some exchanges use, an average of the
first few minutes trading. The LSE is currently estimating the release
of their published end-of-day data service by year end.
Also, how do vendors allow for spurious or invalid trades? Some
automatically reject bad or doubtful ticks, based on cleansing
algorithms. In addition, some real time data providers have a team of
data analysts continuously monitoring the data to remove bad ticks
that would throw out end users charting applications for the rest of
the day. It is the thoroughness and speed of this cleansing process
that really separates data vendors in terms of data quality.
Another key determinant of data quality to look out for is the
application of the appropriate dilution factors (splits and adjustments)
to raw data pricing. The spikes sometimes present in non back-
adjusted data can play havoc with technical analysis indicators. For
example, moving averages and rate of change indicators can and will
provide spurious calculation results that will invalidate back-testing
and market scanning exercises.
In summary, the good news for Investors and Traders globally is that
efforts by organizations such as FISD are great steps forward in
driving accurate and consistent pricing globally. By raising the issue
with the global exchanges and working with them to better define
pricing methodologies, transparency will occur.
Rick Klink is the CEO of Paritech
continued from page 7
Further investigation of the multi-component nature of CRISMA
revealed that it is, in large part, a moving average trading rule. The
impact of the cumulative volume and relative strength components
on observed returns is negative; CRISMA would have produced
slightly improved returns had these components of the system been
ignored!
Over a common time period, application of the objective spreadsheet
version of the CRISMA provided disappointing performance
compared with that obtained using the graphical approach by Pruitt
et al. The sensitivity of the results to various aspects of the model
was investigated but no major individual impacts were identified.
However, it is possible that a set of minor differences in the
application of the model, taken together, could account for the
observed differential performance.
Overall, the results suggest that, at best, the success of the trading
system is extremely sensitive to the exact method of application.
Alan Goodacre is Senior Lecturer in Accounting and Finance at the
University of Stirling and can be contacted by e-mail:
Alan.Goodacre@stir.ac.uk
Further details of the research can be found in the two academic
papers in Applied Financial Economics listed in the references.
Additional information about Applied Financial Economics is
available on the journal publishers web site:
http://www.tandf.co.uk
REFERENCES
Goodacre, A., Bosher, J., and Dove, A. (1999), Testing the CRISMA
Trading System: Evidence from the UK Market, Applied Financial
Economics, 9, 455-468.
Goodacre, A. and Kohn-Speyer, T.K. (2001), CRISMA revisited,
Applied Financial Economics, 11, 221-230.
Kan, R. and Kirikos, G. (1995), Biases in Evaluating Trading
Strategies, Working Paper, University of Toronto.
Pruitt, S.W. and White, R.E. (1988), The CRISMA Trading System:
Who Says Technical Analysis Cant Beat the Market?, Journal of
Portfolio Management, 14, Spring, 55-58.
Pruitt, S.W. and White, R.E. (1989), Exchange-Traded Options and
CRISMA Trading, Journal of Portfolio Management, 15, Summer,
55-56.
Pruitt, S.W., Tse, K.S.M. and White, R.E. (1992), The CRISMA
Trading System: The Next Five Years, Journal of Portfolio
Management, 18, Spring, 22-25.
Is the close price really the closing price?
By Rick Klink
Issue 41 July 2001 MARKET TECHNICIAN
9
Last year stock markets reached unprecedented levels, with
extremely high Price-Earnings multiples and high price volatilities. In
the technology sector share prices of firms that had never posted any
earnings reached extraordinarily high levels. The rise of the New
Economy and the emergence of the biotechnology sector raised
fundamental questions regarding the proper valuation of companies
operating in these sectors. The levels of volatility last year threw
into doubt conventional valuation methodologies. It remained to be
seen whether market valuations were being driven by expectations
of future earnings or by irrationality and overconfidence.
In November, the Financial Markets Group of The London School of
Economics, with the support of UBS Warburg, organised a
conference on Market Rationality and the valuation of Technology
Stocks to analyse key issues, including valuation of firms that
exhibit no earnings and have limited history, aspects of trading
overconfidence in competitive securities markets and market
efficiency in the new environment.
The first session of the Conference was chaired by Hyun Song Shin
(FMG/CEP/LSE) and dealt with Market Efficiency in the New
Environment. The conference opened with Sunil Sharma
(International Monetary Fund) who presented the paper entitled
Herd Behaviour in Financial Markets: A Review co-authored with
Sushil Bhikchandani (Anderson Graduate School of Management,
UCLA).
Motivated by the growing literature in this area, Sharma looked at
the causes for and empirical evidence of herding with particular
emphasis on the Lakonishok-Shleifer-Vishny (LSV) measure and the
so-called learning among analysts. He surveyed the literature
corresponding to the three main causes of herding: (a) information-
based, (b) reputation-based, and (c) compensation-based.
Information-based herding is the belief that analysts are uncertain
about the costs and benefits of their actions and so rely on the
observable behaviour of other analysts, and not their own
information set. The information inferred from actions of
predecessors overwhelms the individuals private set of information.
Reputation-based herding models focus on the idea that fund
managers, unsure of their own abilities and those of their competitors
and concerned about the loss of reputation that may result as their
performances are compared to their peers, will end up imitating each
other. Finally compensation-based herding relies on the idea that
investment managers are compensated on the basis of their
performance relative to a chosen benchmark. If investment managers
are very risk averse, then they will have a tendency to imitate the
benchmark.
Sharma claimed that the empirical evidence of these issues is weak
given that the literature does not examine or test particular models of
herding. Most papers use purely statistical approaches, based on the
idea that the analysis may be picking up common responses to
publicly available information.
The most commonly used measure of herding is the LSV measure,
which defines herding as the average tendency of a group of money
managers to buy (sell) particular stocks at the same time relative to
what could be expected if they traded independently. Using this
measure there is not much evidence of herding in developed markets
but it tends to be greater in small and growth firms and is correlated
with managers use of momentum strategies. The analysis for
emerging markets, although it tends to be less econometrically
robust, indicates that herding behaviour forms much more easily
compared with stocks in larger and more developed markets.
Increased herding is also associated with greater return volatility.
Evidence on herding amongst investment analysts, collected by
Graham (1999), indicates that the likelihood that an analyst follows a
herding strategy is decreasing in his ability, increasing in the
reputation of the analysts newsletter, the strength with which prior
information is held and the correlation of informative signals. Other
literature finds that conditional on performance, inexperienced
analysts are more likely to herd than their older colleagues. Welch
(1999) shows that herding tends to be in the direction of the
prevailing consensus and the two most recent revisions. Such trading
behaviour is stronger in market up-turns than down-turns.
Sharma concluded that it is important to distinguish between
endogenous interactions, contextual decisions and correlated effects
because of the implications for public policy. There is a need for
better characterizations of interactions in terms of preferences,
expectations, constraints and equilibrium. Finally there is tremendous
need for better and more robust data to facilitate credible inference.
The discussant of this paper, Leonardo Felli (LSE/FMG), focused on
the question of how powerful is career-concern herding. He indicated
that comparing the behaviour of direct investors and delegated
manager investment might shed more light on the identification of
reputation-based herding.
The second paper of the session was presented by Kent Daniel
(Kellogg School of Management, Northwestern University). The
paper, co-authored with Sheridan Titman (College of Business
Administration, University of Texas), was entitled Market Efficiency
in an Irrational World.
Daniel explained the predictability of prices by examining the over-
reaction effect in the long term based on the distinction between
tangible and intangible information. Tangible information refers to
accounting measures that are indicative of the firms growth obtained
from its fundamentals; whereas intangible information is accountable
for the part of a securitys past returns that cannot be linked directly
to accounting numbers, but which may reflect expectations about
the future cash flows.
The predictability is broken down into three possible sources: (a)
extrapolation bias (over-reaction to tangible information, as measured
by the book-to-market ration); (b) over-reaction to intangible
information about future growth, and (c) pure noise (price
movements unrelated to future cash flows).
While finding no evidence to support the first effect, Daniel found
that over-reaction to intangible information is a significant factor in
explaining predictability. This is related to the observation that people
tend to be over confident about vague, non-specific information.
The paper was discussed by George Bulkley (University of Exeter),
who questioned the strength of the results. He claimed that,
although the decomposition is interesting, there is difficulty in
determining whether there is support for any particular model. He
claimed that the results presented in the paper were consistent with
any model which generates mispricing measured by the book-to-
market ratio. However, he admitted that there is substantial
econometric difficulty in testing these models given the continuously
overlapping layers of information in financial data and the lack of
discriminating tests.
Countering Bulkleys comments, Daniel argued that the aim of the
paper is to explain long run returns and he did not want to
contaminate the results with effects from the post-earnings
announcement drift.
The second session, covering Overconfidence in the Stock Market,
was chaired by Sudipto Bhattacharya (FMG/LSE) and started with
the presentation of a paper entitled Learning to be Over Confident
by Simon Gervais (Wharton School, University of Pennsylvania).
Gervais developed a multi-period market model describing both the
process by which traders learn about the ability and how a bias in
this learning can create overconfident traders. The principal goal of
this work was to demonstrate that a simple and a prevalent bias in
evaluating a traders personal performance is sufficient to create
markets in which investors are, on average, overconfident.
Overconfidence in markets
10
MARKET TECHNICIAN Issue 41 July 2001
In the model, traders initially do not know their ability. They learn
about their ability through experience. Traders who successfully
forecast net period dividends, improperly update their beliefs; they
overweight the possibility that their success was due to superior
ability. In so doing they become overconfident.
A traders level of overconfidence changes dynamically with his
successes and failures. A trader is not overconfident when he begins
to trade. Ex-ante, his expected overconfidence increases over his first
trading periods and then declines. Thus, a trader is likely to have
greater overconfidence in the early part of his career.
After this stage of his career, he tends to develop a progressively
more realistic assessment of his abilities as he ages. Overconfidence
does not make traders wealthy, but the process of becoming wealthy
can make traders overconfident. Gervais concentrated on the
dynamics by which self-serving attribution bias engenders over-
confidence in traders, and not on the joint distribution of trader
ability and the risky securitys final payoff. In this model,
overconfidence is determined endogenously and changes dynamically
over a traders life. This enables predictions about when a trader is
most likely to be overconfident (when he is inexperienced and
successful) and how overconfidence will change during a traders life
(it will, on average, rise early in traders career and then gradually
fall).
The model predicts that overconfident traders will increase their
trading volume and thereby lower their expected profits. To the
extent that trading is motivated by overconfidence, higher trading
will correlate with lower profits. Volatility increases with a traders
number of past successes. Both volume and volatility increase with
the degree of a traders learning bias.
The model has implications for changing market conditions. For
example, most equity market participants have long positions and
benefit from upward price movements. Therefore it is expected that
aggregate overconfidence will be higher after market gains and lower
after market losses. Since greater overconfidence leads to greater
trading volume, this suggests that trading volume will be greater
after market gains and lower after market losses.
David de Meza (Exeter University/Interdisciplinary Institute of
Management, LSE), the discussant for the paper, commented that he
found the results useful and interesting. He pointed out that the
paper makes a distinction between illusion of validity and
unrealistic optimism (understood as forecast error). He also
emphasized the mechanics of overconfidence by which insiders
overestimate their forecasting ability in the light of accurate forecast.
De Meza finished by agreeing that overconfidence leads to an
increase of trading volume. However he pointed out that it is not
clear why market confidence should fluctuate over time. He
mentioned, in addition, that correlated signals might also mean that
errors are correlated so there was a need for aggregated tests.
The session concluded with the presentation of a paper by Avanidhar
Subrahmanyam (UCLA), entitled Covariance Risk, Mispricing and
the Cross Section of Security Returns. The focus of the presentation
was a model in which asset prices reflect both covariance risk and
misperceptions of firms prospects, and in which arbitrageurs trade
against mispricing.
Subrahmanyam examined how the cross-section of expected security
returns is related to risk and investor mis-valuation. He provided a
model of equilibrium asset pricing in which risk averse investors use
their information incorrectly in selecting their portfolio. The model
was applied to address the ability of risk measures versus mis-pricing
measures to predict security returns; the design trade-offs among
alternative proxies for mis-pricing; the relation of volume to
subsequent volatility; and whether the mis-pricing equilibrium can
withstand the activities of smart arbitrageurs.
The presenter stated that may empirical studies show that the cross
section of stock returns can be forecast using not only standard risk
measures, such as beta, but also market value or fundamental/price
ratios such as dividend yields or book-to-market ratios. The
interpretation of these forecasting regressions is controversial,
because these price-containing variables can be interpreted as proxies
for either risk or mis-valuation.
Subrahmanyam also pointed out that, so far, this debate has been
pursued without an explicit theoretical model. This paper presents an
analysis of how well, in this situation, beta and fundamental/price
ratios predict the cross-section of security returns.
The model implies that even when covariance risk is priced,
fundamental-scaled price measures can be better forecasters of
future returns than covariance risk measures such as beta. Intuitively,
the reason that fundamental/price ratios have incremental power to
predict returns is that a high fundamental/price ratio (e.g. high book-
to-market ratios) can arise from high risk and/or overreaction to an
adverse signal. If price is low due to a risk premium, on average it
rises back to the unconditional unexpected terminal cash flow. If
there is an overreaction to genuine adverse information, then the
price will on average recover only in part. Since high book-to-market
reflects both mispricing and risk, whereas beta reflects only risk,
book-to-market can be a better predictor of returns.
Subrahmanyam concluded with an examination of the profitability of
trading by arbitrageurs and overconfident individuals. He further
mentioned that it would be interesting to extend the approach to
address the issues of market segmentation and closed-end fund
discounts.
Sudipto Bhattacharya, (FMG/LSE) the discussant for this paper,
pointed out that the model presented in the paper introduces
investor psychology to theory of capital asset pricing by integrating
risk measures (CAPM) with overconfidence (mispricing). He asked
whether the misvaluation effects identified in the model could persist
in the long run and hypothesised that investors may become
overconfident about a theory of how the stock market functions
rather than about the realization of a signal.
Bhattacharya further commented that it would also be interesting to
investigate the correlation between signals and future returns as well
as the implication of univariate equilibrium conditions. He was
excited about the further research suggested by Subrahmanyam,
especially regarding how different groups of investors fasten their
overconfidence upon one analysis versus another, and how the social
process of theory adoption influences security prices.
The third session dealt with Analysts Forecasts and Pricing in the
New Economy and was chaired by Bob Nobay (FMG/LSE). Peter
David Wysocki (University of Michigan) presented a joint paper with
Scott A Richardson (also University of Michigan Business School) and
Siew Hong Teoh (Ohio State University) on The Walkdown to
Beatable Analyst Forecasts: The Role of Equity Issuance and Insider
Trading Incentives.
Motivated by the observation that in the last couple of years,
earnings announcements that exceed analysts forecasts and
subsequent jumps in share prices have become more frequent,
Wysocki asked whether this fact can be statistically explained, and
whether there is a plausible story to be told for why this should
happen.
In this context, he concentrated on the question of whether firms
play an earnings-guidance game where managers release
information selectively to bolster the share price, thereby producing
some benefit either directly for themselves or for the future equity
issuance programmes of the firm.
Comparing US companies in the 1980s to the 1990s, he observed
that there has been a trend towards stock-based compensation that
should give managers incentives to influence the stock price. In
addition, he alluded to mainly firm-initiated rules on insider trading,
restricting it to time periods immediately after earnings
announcements; the argument here apparently being that in these
periods, there would be less insider information to trade on.
Furthermore, changes in US rules on insider trading initiated by
regulators in May 1991 imply that managers now have a more
precise target date for when to exercise their stock options. Given
these structural changes in the 1990s, Wysocki argued that there are
now higher incentives to achieve beatable forecasts. One would also
expect a higher likelihood of observing pessimistic forcasts for firms
with greater needs to sell stock after an earnings announcement:
firms that want to issue stock in the future have an incentive to
generate a greater number of positive earnings surprises.
Issue 41 July 2001 MARKET TECHNICIAN
11
The paper calculates ex-post forecast errors from the Institutional
Brokers Estimate System (I/B/E/S), which contains individual
analysts, monthly forecasts, from 1983 to 1998. The short-term
errors (e.g. one month prior to the earnings announcement) are then
regressed on sub-period dummies, controlling for various other
variables, to determine whether there has been a shift in pessimism.
The results suggest that there has indeed been a shift towards small
negative forecast errors in the 1990s. Further, from a cross-section
regression, Wysocki found that the effect is indeed stronger for firms
that issue equity after the earnings announcement, and/or where
insiders sell the announcement.
From this evidence, he concluded that institutional changes have
made managers more likely to behave opportunistically and guide
analysts expectations through earnings announcements in order to
facilitate favourable insider trades.
In his discussion of the presentation Pascal Frantz (LSE) reviewed the
main features of the paper, and suggested that there may be several
other reasons why forecasts are systematically pessimistic. He also
proposed examining whether the magnitudes of differences of
observed share price movements were economically significant, and
whether they actually allow non-negligible profits to be made.
Next Enrico Perotti (University of Amsterdam) presented joint work
with Sylvia Rossetto (University of Amsterdam), entitled The Pricing
of Internet Stock Portals as Platforms of Strategic Entry Options.
The main motivation behind the presentation was to show how one
could calculate valuations for companies that have a significant
proportion of their value tied up in growth opportunities.
Perotti presented a model based on the concepts of strategic real
options and platform investment. Platform investment is the creation
of an innovative distribution and production infrastructure, which
increases access to customers and as a result reduces entry costs in
related products. Examples include the development of a software
operating system or an internet portal web page. Having a platform
technology confers strategic pre-emptive advantages, creating a set
of entry options into uncertain markets.
In the model, two firms compete as parallel monopolies in a market
with two differentiated products, and contemplate cross-entry into
the other firms market. Demand in the market evolves stochastically
over time and follows a geometric brownian motion. In the absence
of strategic considerations, the standard argument applies there is a
positive value to waiting due to the fact that profits are convex in
demand. Here, however, strategic interaction creates a first-mover
advantage. In the model, there is a tension between these two
effects. Asymmetry is introduced by giving one firm the platform
technology, essentially lower costs of cross-entry, and the other one
conventional technology.
Depending on parameter values, there are three different possible
outcomes: (a) there is no cross entry, (b) the platform firm cross-
enters, but the conventional firm does not follow, producing a de
facto monopolist, or (c) the platform firm leads and the conventional
firm follows. In the latter two cases, the platform firm will derive an
advantage from its technology. The central result that emerges is one
where, with higher uncertainty, the platform strategic advantage
increases and firms tend to behave more as a de facto monopolist.
Perottis presentation was discussed by Pierre Mella-Barral (London
Business School), who reviewed the model and suggested some
simplifications in the exposition of the model, as well as proposing
the introduction of a choice between investing in conventional or
platform technology as an additional stage in the game.
The second day of the Conference opened with a session in which
the Valuation of Technology Securities was discussed. The session,
chaired by Bob Nobay, opened with a paper presented by Meir
Statman (Leavey School of Business, Santa Clara University), which
was a joint work with Kenneth L. Fisher (Fisher Investment Inc.) and
entitled Cognitive Biases in Market Forecasts.
Statman discussed several cognitive biases that people are likely to
have in making market forecasts, presented examples related to the
importance of Price-Earnings ratios for forecasting stock prices, and
drew implications for good investment management practice. The
five types of bias they discuss are (a) overconfidence, (b)
confirmation, (c) representativeness, (d) anchoring and (e) hindsight.
Overconfidence refers to those forecasts made with a precision that
is too high, a mistake that psychological studies show people make
very often people tend to attach too much significance to imprecise
information they receive. Confirmation refers to the case when
people choose to look exclusively at data that supports their
preferred hypothesis. Representativeness alludes to forecasters
reaching conclusions by comparing one security or group of securities
to another, but in an inappropriate way. There is a bias towards
highlighting similarities and ignoring differences across different time
periods. The anchoring bias involves the tendency to anchor
estimates to salient numbers even if these numbers have little or no
relevance to the estimates. For example, people might have
expectations of the level of the market related to the 1929 crash,
even though future levels of the market might not be related to the
level of the crash at all. Another cognitive bias arises when we know
the reason for market events ex post, and use these to overestimate
the quality of forecasts that happen to be right. Of course, with
hindsight it is easy know which was the best forecast, but is ex ante
accuracy will in general be lower than its ex post accuracy.
As remedies, Statman stressed the importance of checks and balances
through an appropriate organisation of decision making, and the role
of colleagues and committees in making sense out of forecasts.
Competing views can moderate one another, which might serve to
suppress cognitive biases. The presenter also highlighted the
importance of quantitative tools in providing a guide, although they
come with their own pitfalls and limitations. Summing up, Statman
stressed the need to be humble about ones own forecasting abilities,
and the need to recognise the true nature of the financial services
industry, that its not about making excess returns, its about selling
hope.
Gregory Connor (FMG/LSE), gave a brief synopsis of the paper, and
extended the idea of the need to be aware of cognitive biases from
the investment management discipline to the production of scientific
research. In trying to find academic explanations for asset markets
behaviour, he argued, we must also be aware of not falling prey to
the same biases.
The next presentation saw Josef Lakonishok (University of Illinois
Urbana-Champaign) present a joint paper with Lous Chan and
Theodore Sougiannis (all at the College of Commerce, University of
Illinois Urbana-Champaign) on The Stock Market Valuation of
Research and Development Expenditures.
The problem that the Lakonishok tackled is how to value intangible
assets, taking the concrete example of Research and Development
Expensiture (R&D). In the US, accounting standards require that R&D
be expensed rather than capitalised. However, if todays R&D
provides benefits in the future then, in principle, this suggests that
such an item should be capitalised this in general would lead to
initially higher earnings and, of course, bigger balance sheets.
The question then is: do capital markets take account of R&D in the
correct way, and are R&D stocks fairly priced? A consequence of
expensing R&D for financial analysis would be that Price Earning
ratios or Price to Book ratios might not be reliable, and stocks could
be underpriced. On the other hand, investors might be too optimistic
about R&D intensive stocks, leading to the opposite mistake being
made.
To answer these questions, Lakonishok examined Compustat
datasets, and calculated returns of portfolios of stocks with different
R&D intensity, measured either as R&D spending to sales, or as R&D
spending to market value. He found that, for the first measure,
stocks with a high R&D intensity tend to show the same performance
as stocks of companies that do not perform R&D.
For the second measure, however, R&D intensive companies exhibit
an excess average annual 3-year return in the range of about 6 per
cent. Lakonishok reported that when he sub-divided this last
portfolio into companies with high sales and companies with small
sales, they find that companies with high sales tend to outperform.
The explanation that he provided is that high sales/high R&D
companies are relatively large and developed companies (rather than
high-tech start-ups) that have underperformed prior to the
observation period, possibly due to the fact that analysts do not
account for R&D properly. Arguably, it is the fact that analysts do no
12
MARKET TECHNICIAN Issue 41 July 2001
capitalize R&D that is causing the mis-pricing of these stocks, leading
to the outperformance later on. He also cast the analysis in a more
rigorous Fama and French three-factor regression model, and arrived
at similar conclusions.
In his discussion, Ian Tonks (University of Bristol/FMG) stated that
even though, in principle, R&D should be capitalised, there are
important reasons not to allow this, since this might create the wrong
kind of incentives in terms of the appropriate financial reporting. He
agreed, though, that analysts must impute capitalisation if they want
to arrive at reasonable values. He suggested that future research
should consider a comparison with the UK where the capitalisation of
software development is allowed.
David Webb (LSE/FMG) chaired the fifth session which dealt with
Valuation of Internet Securities. The first paper presented by
Stephen Cooper (UBS Warburg) was entitled Navigating the
i-Valuation Jungle. It focused on the challenges encountered for
valuation and financial analysis of internet based companies. Cooper
highlighted the fact that traditional methods and techniques for
valuation, traditionally based on accounting numbers, are not suitable
for the analysis of internet companies.
The major difficulty is that accounting profits are poor indicators of
future performance for companies in this sector. Despite the fact that
uncertainty is present in valuation of old economy companies, the
situation becomes somewhat more complicated in the internet sector.
For these companies, the history of past results is not long enough to
allow any inferences and more importantly, the real value drivers
have not been well established.
The paper contained a model for absolute valuation based on the
traditional discounted cash flow model and target multiples. The
model is based on the input of key data (revenue growth rate, cost
of capital, business margin, etc) which generates target multiples for
valuation which are compared with the current patterns for those
companies. The author also commented on the real option valuation
framework, criticising its empirical validity.
The next presenter was John Hand (Kenan-Flagler Business School,
University of North Carolina-Chapel Hill) with the paper Profits,
Losses and the Non-Linear Pricing of Internet Stocks. His central
theme was how accounting information can help in the valuation
process of internet-based companies. The major hypothesis was that
accounting should not be relevant to explain the behaviour of
internet-based stocks, because traditional accounting rules (US-GAAP
on the paper) focus on the evaluation of tangible assets.
He criticised traditional accounting research which assumes a linear
and stable relationship among the variables. Those assumptions,
Hand argued, are not realistic due to characteristics of the accounting
system such as conservatism (biased recognition). The paper
evaluates the value relevance of profits, losses, intangibles and the
linearity assumptions. There is evidence that the pricing of
accounting information for internet stocks is non-linear.
First, losses are priced negatively though they may be caused by
huge investments in intangibles and R&D and need not be associated
with poor performance. Second, intangibles are priced as expenses
when income is positive and priced as assets when income is
negative. The authors explanation for this phenomenon is that the
stock market only attributes future benefits to intangibles when they
play a significant role in the firms strategy. This is exactly what
happens for loss-making firms that spend more than twice as much
of their revenues on intangibles as do profit-making firms.
Finally the paper reports that when income is positive, operating
gross margin is more positively priced than when income is negative.
These results show that the traditional assumptions of accounting-
based valuation (linearity and constancy of the parameters over time)
are not appropriate for internet firms.
Eli Talmor (London Business School), discussing the paper,
commented on the originality of the paper and the need for caution
in interpreting results from research that is contemporaneous to the
data. He also pointed out that internet firms provide a good
laboratory to test established theories and that the econometric
design of these studies must be improved.
The third presenter of the day was Baruch Lev (Stern School of
Business, New York University) with the paper A Rude Awakening:
Internet Value Drivers in 2000. His paper aimed at identifying value
drivers for business-to-consumer (B2C) internet companies both
before and after the internet bubble in the spring of 2000. The
paper uses a relative valuation approach (cross-section) considering
web traffic performance, strategic alliances, cash and traditional
financial indicators. Lev pointed out the intrinsic difficulties in the
absolute valuation approach, considering it an exercise of educated
guess and excessively complicated. The paper presents evidence or
correlation between monthly stock returns and lagged web traffic
metrics and also discriminates between the most relevant dimensions
of web traffic performance: reach, stickiness and customer loyalty.
Lev also showed that investors apparently capitalise R&D and
marketing expenses during the bubble period and that this is no
longer taking place after the shakeout in the spring of 2000.
Finally, his empirical model seemed to be able to identify over-valued
internet stocks over the sample considered in the study. The
discussant, David Blake (Birkbeck College) commented on the
accuracy and reliability of accounting data for internet companies
and suggested improvements related to other performance measures
and longer datasets.
The last section of the conference was a Round Table chaired by
David Webb (LSE/FMG) with the title Valuation Models for
Technology Stocks: Value Driven or Going With The Wind?. The
participants of the Round table were Ron Anderson (LSE/FMG),
Walter Kemmsies (UBS Warburg), Josef Lakonishok (University of
Illinois at Urbana-Champaign), Peter Martin (Financial Times), Miguel
Ortiz (Boston Consulting Group) and Kent Daniel (Kellogg School of
Management, Northwestern University). Each speaker began with
some brief comments, which were followed by a lively discussion.
Daniel started by commenting on the anomalies found in recent
studies and how these are inconsistent with the rational expectations
model. He pointed out that overconfidence has a strong role in
market behaviour and that in general people are more overconfident
when the situations are fuzzy; this point has not been established
in the existing models. However, this kind of behaviour does not
necessarily create opportunities for arbitrage.
Lakonishok noted that there is no evidence of companies providing
the high returns over a long period of years implicit in the high
market prices we have seen for some internet companies. He
observed that growth rates in this sector are almost unpredictable,
and that they are excessively dependent on technological
developments that are not captured by traditional valuation models.
Kemmsies emphasised the importance of empirical considerations and
commented that many of the challenges presented by internet-based
companies, such as high growth rates and valuation of growth
options, are being felt in other sectors as well, such as the telecom
companies.
Anderson observed that the high volatility of those markets makes it
almost impossible to discriminate between alternative hypotheses. In
such a scenario it is hard to extract relevant information from the
data. He went on to support the argument that technological events
make the forecasts of growth rates very much a hopeless task. He
also questioned what really differentiates losers from winners in those
markets and if analysts evaluations were really time-consistent.
Ortiz focused on the importance of the New Economy for the
Old Economy pointing out that, as a consultant, he has to focus
on strategic issues related to the creation of value. He highlighted
that the value drivers that had been discussed in some of the papers
are of extreme relevance for managers. He also discussed the limited
scope for valuation based on market values and questioned the role
of the fundamentals for the firms involved in the New Economy.
Martin presented his view that traditional investment theory is not
well suited for the new type of technology firms that are being
formed. He analysed the enormous impact of internet based
technologies on real activity and the consequent transfer of wealth
among agents which may be creating an environment for
overinvestment.
continues on page 13
Issue 41 July 2001 MARKET TECHNICIAN
13
After these first comments the general discussion, with questions from
the floor, focused mainly on the valuation of internet firms and the
possible reconciliation with existing valuation models. The valuations
of technology securities over the recent past seem to suggest that
every single firm in this sector will be a winner when there is
evidence that suggests that, in every sector, there are winners and
losers. The distinction between firm types has been blurred for
technology firms, mainly through highly exaggerated growth rates.
The nature of accounting information and its use by analysts was a
major issue addressed. Other comments focused on the incentive of
investment bankers, brokers and analysts, mainly referring to the fact
that the number of buy recommendations have been, and continue
to be, much larger than hold and sell recommendations. It was
suggested that such recommendations are likely to lead to
overconfidence in valuations.
After a round of comments and questions from the audience, David
Webb brought an end to the two-day Conference, and thanked the
presenters and participants for a very lively and stimulating
conference, which helped not only encapsulate the current thinking
but also clearly laid the themes which are a priority for further work.
This article first appeared in the Financial Markets Review. FMG
Review April 2001 pp 1-5, 14-15, Number 50
The conference papers are available at http://fmg.lse.ac.uk under
events, past conferences, market rationality and the valuation
of technology stocks.
I will bind a copy and place it in the STA Library (M. Feeny)
The Way To Trade Discover Your Successful
Trading Personality
By John Piper FT/Prentice Hall (Pearson Education); 1999; 282pp; hardback
John Piper is a long-time newsletter writer and money manager, who
has strong views on particular aspects of technical analysis,
particularly indicators, Market Profile, and behavioural finance. The
first he (generally) despises, the second two he strongly favours.
Much of the book (as the sub-title suggests) has to do with the third,
the psychological aspect of trading. The title is valid in another
respect this is a primer for traders, rather than investors (even
though longer-term traders would also doubtless benefit from its
lessons) since much of the content relates to trading in equity futures
and options, mostly in the UK markets.
John has no shame in admitting his mistakes, but equally he takes
pride in where these mistakes have taken him to a secure position
as one of the UKs leading newsletter writers, and a money manager
well on the way to earning his CTA (which takes a five-year audited
track record). It is educational to see how he has got there.
It is also interesting to see who has had particular influence on his
thinking. One Appendix (out of five) is a reprint of a Tony Plummer
article on the brain. The introduction is by Alexander Elder
(psychologist, trader, and writer of Trading for a Living, a splendid
book for those seeking self-knowledge). Acknowledgements are made
to Adrienne Laris Toghraie, a well-known US traders coach and writer
and coach to John Piper himself. But the main influence has been
Johns own trading, and it is fascinating to discover what he has learnt.
Each chapter of the book (which itself is split into two main sections and
two smaller ones) ends with a summary of the topics discussed, and
these are excellent reminders of what might need to be re-read when
returning to the work. A quick riffle through the pages is not going to
be productive; there is a lot to be learnt here, as the trader is taken
through the various stages of how best to hone his skills.
This book is written in a down-to-earth and practical style. You may not
agree with all he says (particularly regarding indicators!), but you will be
stimulated into thinking about why you might disagree with him, and
that thinking process may to help you to become a better trader.
Aggravating? Yes. Stimulating? Yes. Worth the read? definitely.
M. Smyrk
TraderMade
TraderMade has developed a range of desktop applications and
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been designed as a browser version for total portability, with users
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clients website, and TraderMade Charting is a plug-&-play applet
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own technical analysis direct from the client's web-site. Prices are
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of an attractive global sliding price scale.
For more details, visit us at www.tradermade.com
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Virtual Trading Seminars on CD
Clickevents.co.uk distribute a series of recorded training seminars on
CD, the Microtrader seminars work out at under 20 and under a
current special offer have a past seminar CD for under 5.00. These
seem great value for money to me, so you may wish to check it out.
www.clickevents.co.uk
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Metastock Portfolio level Testing
The ability to carry out portfolio level testing has been lacking from
many technical trading packages, Metastock included. But now with
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Details can be found at http://www.holygrailsoftware.com/msbt.shtml.
Cost $45. The site also offers a variety of other Metastock tools.
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Gobal Stock Selection and filtering
The Henley Investor Suite of stock selection investor tools enables
you to select and filter the most promising stocks for analysis. Unlike
many vendors Henley offers a variety of both UK and overseas data
packages, allowing gobal stock charts to be compared. Also included
in charting package.
www.henleyinvestor.co.uk Tel: (44) 020 8332 1094
* * * *
Trading and Tradestation Support in the UK?
Scalper UK offer trading support and free seminars in Covent Garden
promoting their methods of trading the Emini futures contract using
Tradestation via an indicator package. Pity there was no defined
system tests, but their seminar covered the several aspects of setting
up a trading desk. You can register for their free seminar via their
website www.Scalper.co.uk Scalper also offers Tradestation Support
and Sales.
Bytes and Pieces
David Watts
Book Review
14
MARKET TECHNICIAN Issue 41 July 2001
Introduction
This talk will discuss three models of future price movement, one
which is to all intents and purposes totally random and directionless,
one which has a modest element of non-random (or directional)
behaviour, and one in which there is a higher element of non-
random behaviour (directional) behaviour. Techniques will be given
which can take advantage of the characteristics of these models to
generate increasingly large profits.
Model 1 Totally random
An underlying assumption in the valuation of options is that past
daily changes in the price of the underlying security followed the
normal distribution. A second assumption is that future prices, at
least in the short term, will follow this same distribution. The
distribution is easily calculated from a knowledge of the volatility of
the security. From this the probability of occurrence of various price
levels for the security at some point in the future, for example in 30
days time, can be determined.
Figure 1 shows a plot of Marks and Spencer up to 8th June 2001
(price = 252.5p) with the probability distribution for its price 30 days
onwards. From this curve probabilities such as the price being greater
or less than a certain level, or staying within a particular price band,
or being an exact value on the day 30 days into the future can be
estimated.
Such techniques are used extensively in options strategies, for
example in the buying or writing of straddles. A straddle involves the
buying or selling of both a call and a put at the same exercise price.
The upper and lower break-even points lie above and below the
current price and are readily calculated from the premiums. The
buyer of the straddle is expecting the price to move outside either of
the two break-even points and doesnt particularly care in which
direction the large move takes place, while the writer is expecting the
price to stay between the two points. Thus the buyer wants the
future volatility to be high while the writer wants it to be low. The
probability curve can be used to calculate the probabilities of making
a profit for either buyer or seller.
In view of the fact that it is easily demonstrated that share price
movement does not follow the normal distribution, it is difficult to
understand why this method is still followed so widely. When the
daily price changes of a share are plotted as an histogram, it becomes
obvious that there are price movements which are much larger than
expected (in statistical speak the tails of the distribution are too long).
Figure 2 shows the frequency of various daily price changes for
Marks and Spencer over the last 1000 days. The largest one day fall
was 53.75p and the largest one day rise was 40p. At the time these
occurred they represented changes of 13.6% and 18.1%. A number
of other large changes can be seen, for example falls of 45p and 30p
and rises of 40p, 37p and 35p. On the basis of a normal distribution
of daily price changes, the probability of these large changes
occurring is vanishingly small. The fact that they occur therefore
negates the use of the normal distribution of daily price changes as a
way of calculating future prices. Thus the conclusion is that although
this model assumes a totally random price movement, the
distribution upon which this price movement relies is something other
than the normal distribution.
The approach I have developed to determine future price levels
assuming a random model is to use the actual price changes
themselves, such as those shown for Marks and Spencer. These
changes should be calculated for a period back in time of at least
four times the period into the future for which the price levels are
required. Thus, taking the 1000 daily changes for Marks and Spencer,
it is possible to look ahead for 250 days. One simulation of the
future price movement is then obtained by, as it were, putting all of
these changes into a pot and taking them out one at a time until 250
have been taken. The first change taken out is added to the current
price to produce the estimated price for tomorrow. By this means, the
price can be rolled forward a day at a time as each successive price
change is taken out of the pot and added to the latest price. This
process is known as bootstrapping.
By itself, this one simulation is meaningless. In order to build up
probabilities for the future it is necessary to run the simulation say
1000 times. None of these simulated future price movements will be
identical with the actual price movement that occurs, but the purpose
of the exercise is to see what proportion of these simulated price
movements take the price above or below specified levels in the look
ahead period. Some of the simulations will violate both price levels.
In the case of options where a straddle is envisaged, the price levels
would be the upper and lower break even points.
In Figure 3 are shown the results for Marks and Spencer. The levels
chosen here are 220p and 300p with the latest price standing at
252.5p.Three time scales are used, representing the near, middle and
far expiry dates. The results are presented as probabilities that the
price will be outside these limits. The possibilities are to be outside
one limit, or outside both limits, and the position at expiry is also
specified.
It can be seen that, for example, in the 1000 simulations, the price
moved outside of one or other of the limits 818 times (81.8%)
during the 40 day period, 993 times (99.3%) during the 131 day
period and 1000 times (100%) during the 222 day period. An option
trader with a straddle that required the price to move either above
330p or below 220p during the next six or nine months would have
a very high probability of success. In checking this method for a
large number of situations over the last five years, all those
instances in which the estimated probability has been over 99% has
resulted in the price moving outside of one or other of the two
Predicting future price movement
This article is a summary of the presentation given by Brian Millard for the STA meeting in April 2001
Figure 1
Figure 1: The probability distribution for the Marks and Spencer price 30 days on from 8th June 2001.
Figure 2
Figure 2: The frequency of daily price changes in Marks and Spencer over the last 1000 days.
Issue 41 July 2001 MARKET TECHNICIAN
15
limits. Thus, quite clearly, it is possible to generate consistent profits
even if it is assumed that price movement is virtually totally random.
Model 2 Partly random
It can be demonstrated easily that share price movement is not
totally random, but has at least a modest directional element which
can be subjected to predictive techniques with a high degree of
success. The directional element is due to the presence of cycles in
the data, and as an example, the algebraic sum of the cycles with a
nominal wavelength of between 21 and 41 weeks are shown for
Halifax shares in Figure 4(upper panel).The lower panel is the plot of
the weekly closing values of Halifax over the same period of time,
and it can be seen quite clearly that major peaks and troughs in the
data coincide with peaks and troughs in the cycle. The regularity of
the cycle is quite impressive, with modest changes in amplitude and
wavelength across the time frame which are caused by random
influences.
The method of isolating narrow bands of cycles is to select the upper
wavelength of interest as an odd number (41 in the case of the
Halifax example) and calculate a centred average using the same
span of 41. Then take the nearest odd number to one half of this
span, i.e. 21 in the current example and calculate a triangularly
weighted centred average. The difference between these two
averages when plotted gives the narrow band of cycles as shown in
Figure 4. The plot will end half of the higher span back in time since
the calculation is based on centred averages. The path of the cycles
since that time can be estimated by various mathematical techniques,
but it must always be remembered that the latter part of the plot is
indeed an estimate.
The predictive value of these cycles is enhanced by calculating a
number of them separated fairly widely in wavelength. Thus in Figure
5 is shown the band of cycles with nominal wavelength between 15
and 31 weeks. Both Figures 4 and 5 show the position as at
September 2000, and it is estimated that the 15/31 week cycles have
just passed their bottom, while the 21/41 week cycles have a little
way to go before bottoming out. Thus the interpretation of these
results is that in a few more weeks the cycles will be rising in unison
and should take the share price with them. The vertical sweep of the
cycles is in pence and can be used to estimated the contribution
which they will make to the share price. Thus the 15/31 week cycles
should give a rise of around 80p and the 21/41 cycles a rise of 100p.
The arithmetical sum of these two is 180p, and this is the expectation
of the rise which should follow if these two cycles are still in
evidence. That this method can be extremely accurate is shown by
the subsequent movement of Halifax shares from September 2000 to
February 2001 (Figure 6). A substantial upwards movement occurred
taking the price up by nearly 200p. Thus, not only does the analysis
of cycles present in share price data give valuable information about
the start of a trend, but also of by how much it can be expected to
cause the price to change.
Model 3 Highly directional
Moving averages, especially triangularly weighted ones, represent the
net result of all of those cycles with wavelengths more than 1.5 times
the span of the average. Since a trend can be considered to be one
half of a cycle (either the rising or falling half), then the average is a
good representation of all of those trends which have a time scale of
about three-quarters of the span of the average. This is true, however,
only if the average is plotted as a centred average. Taking Boots as an
example, a 201 day centred, triangularly weighted average is shown
superimposed on the daily share price up to 6th April 2001 in Figure
7. The fact that various sections of the plot of the average follow
faithfully the overall direction of the price illustrates the relationship
between trend and centred average quite clearly.
What is also obvious is that excursions of the price away from the
position of the centred average are quite limited in extent. The
largest excursions can be contained between two boundaries set
equidistant above and below the position of the average. These
boundaries are therefore exact duplicates of the centred average
itself as far as shape is concerned. These two boundaries form a
constant depth channel within which the price movement is
Figure 3
Figure 3: The results from 1000 simulations of the Marks and Spencer share price over the next 222 days
using as a source the daily price changes from the last 1000 days.
Figure 5
Figure 5: Upper panel: Cycles of wavelengths between 15 and 31 weeks in the Halifax share price.
Lower panel: Halifax share price as weekly data.
Figure 6
Figure 6: The subsequent movement of Halifax share price to February 2001.
Figure 4
Figure 4: Upper panel: Cycles of wavelengths between 21 and 41 weeks in the Halifax share price.
Lower panel: Halifax share price as weekly data.
16
MARKET TECHNICIAN Issue 41 July 2001
contained. The drawing and estimation of the current and future
positions of these boundaries constitute the technique of channel
analysis. Since the share price normally reverses direction once it
arrives at the channel boundary, the description of this model as
highly directional can be understood.
In Figure 8 the boundaries have been drawn so as to enclose some
97% of the price data points. It is permissible to allow a small
tolerance in placing the boundaries so that small penetrations of
either boundary can occur if this brings a large number of price
peaks and troughs to the boundary positions. It is remarkable at
how many places the price reaches a boundary and then reverses
direction. Note that since the channel is based on a centred average,
it terminates half a span of the average back in time from the
present. There are mathematical techniques which can predict the
path of the channel from this cut-off point up to the present time
and beyond. The channel boundaries represent places where there is
a low probability of the price remaining for more than a day or two.
There is a high probability that the price will reverse direction, and a
lower probability that the price will continue in the same direction.
Thus the high probability is that the channel boundaries represent
areas where a new trend will probably start. Not only that, but since
the channel contains the price within it, the general channel
direction is also of importance since it gives an indication of the
longer term trend.
In the case of Boots this long term trend can be estimated as rising,
and it can be expected that the price will eventually (in the next few
months on from April) meet the lower boundary of this rising
channel and be converted into a rising short term trend. The rate at
which the short term trend causes the price to rise will then be
augmented by the rising outer channel.
Rentokil in 1999 is an example where the price did not reverse
direction but continued outwards from the channel boundary. Thus
in Figure 9 is shown the position on the 7th May 1999. It would be
anticipated that the price would bounce up from the lower
boundary, which is at about 360p, to a level somewhere around
480-500p. However, as can be seen from Figure 10, the price made
a disastrous fall through the estimated lower boundary to the 240p
level. When looked at in retrospect, it can be seen that the channel
made a rapid downward hook at this point, taking the price down
with it.
In practice, the ratio of occasions in which the price retreats from the
boundary to those occasions where the price continues through the
boundary is about five to one. A stop loss is essential to protect the
investor against such possible adverse moves. Options traders can of
course take a position which will take advantage of this five to one
ratio.
Brian Millard is the author of five books on technical analysis
published by Wiley in the UK and a sixth Channels and Cycles
published by Traders Press Inc in the US. He owns Qudos
Publications Ltd which carries out independent research on
mathematical methods of analysing stock markets.
Figure 8
Figure 8: The average from Figure 7 has been used as a template to produce a constant depth channel.
The channel has been extrapolated to the present time.
Figure 9
Figure 9: The position for Rentokil in May 1999 suggests a rise from the lower boundary should occur.
Figure 10
Figure 10: The subsequent movement of Rentokil.
Figure 7
Figure 7: A 201 day triangularly weighted centred average superimposed on the Boots share price.
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