Sunday, January 16, 2011

Fed Paper: Power of Technical Analysis in Forex is Declining

Being a practitioner of fundamental analysis, you could say that I’m always on the lookout for hard evidence that fundamental analysis is superior to technical analysis. Thus, I was delighted to discover a working paper (“Technical Analysis in the Foreign Exchange Market“) by the St. Louis Branch of the Federal Reserve Bank, released just this month. Alas, the paper barely touched upon fundamental analysis, but its conclusions on technical analysis in the currency markets were startling. In short, the effectiveness of technical analysis in the currency markets has declined steadily since the 1970s, such that only the most sophisticated/complicated strategies are currently profitable.

Rather than conduct original research, the report’s authors â€" Christopher J. Neely, an assistant vice president and economist at the Federal Reserve Bank of St. Louis, and Paul A. Weller, the John F. Murray Professor of Finance at the University of Iowa â€" performed a meta analysis of the existing research. They cited a litany of studies, covered a variety of topics, sometimes with contradictory conclusions. In order to ensure comprehensiveness, they looked at the profitability of numerous types of technical analysis indicators, across numerous currency pairs, over time, in different types of trading environments, and adjusted for risk.

All of the earlier studies, dating back to the 1960s, established the profitability of technical analysis, even when it was simplistic. Since then, however, most studies have shown steadily declining effectiveness: “TTRs [Technical Trading Rules] ere able to earn genuine risk-adjusted excess returns in foreign exchange markets at least from the mid-1970s until about 1990…and that rule profitability has been declining since the late 1980s.” The same trend has unfolded in the last decade, as traders have relied increasingly on computerized trading strategies: “Kozhan and Salmon (2010), using high frequency data, find that trading rules derived from a genetic algorithm were profitable in 2003 but that this was no longer true in 2008.”

Given that the two authors also concede that the financial markets are undoubtedly inefficient and that currency markets in particular are filled with observable trends, how should we understand this decline in the effectiveness of technical analysis? In one word, the answer is competition. “Profit opportunities will generally exist in financial markets but…learning and competition will gradually erode ["arbitrage away"] these opportunities as they become known.” In addition, there has been a “dramatic rise in the volume of algorithmic trading,” which has given rise to a so-called financial arms race to develop ever-more sophisticated trading strategies.

Indeed, the research shows that “more complex strategies will persist longer than simple ones. And as some strategies decline as they become less profitable, there will be a tendency for other strategies to appear in response to the changing market environment.” In addition, technical analysis that is used to trade exotic (i.e. less liquid) currencies is more likely to be profitable than major currencies, especially the US Dollar.

The report opens the door to further research, by indicating that “Technical trading can be consistently profitable in certain circumstances.” As if it wasn’t already clear, though, the vast majority of technical traders (perhaps all traders for that matter) are destined to be outmaneuvered and will ultimately lose money trading forex. Another way of looking at this, however, is that the the savviest traders â€" those that can spot complex trends and execute trading strategies quickly â€" still have a chance at earning consistent profits.

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