Technical Indicators in Momentum Trading

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Technical indicators are mathematical calculations based on historic price, volume, or open interest information that aim to forecast future market behavior. In general, technical analysis focuses on trends and patterns in the price of an underlying instrument such as a stock or commodity.

We recently discussed a paper that studied the profitability of popular technical indicators during the pandemic. In a similar context, Reference [1] examined the performance of 14 technical indicators for a longer period of time. The investment strategy is as follows.

At the end of each month, the technical indicators were used to estimate the stocks’ expected returns for the next month. The stocks then were sorted into ten value-weighted (equal-weighted) portfolios based on their estimated returns, and firms with the highest (lowest) expected returns were selected into the top (bottom) investment portfolio. The stocks in the top portfolio were bought and the stocks in the bottom portfolio were sold.  This position was held for one month and the strategy was rebalanced monthly.

The authors found out,

Our results show that technical indicators generate lower estimation error than the Fama French three-factor model and exhibit statistically significant out-of-sample explanatory power in determining cross-sectional equity expected returns, and the result is significant over time. The traditional time-series out-of-sample and the 𝑅2 𝑇𝑆𝑂  cross-sectional out-of-sample defined by Han, He, Rapach, and Zhou (2020) are positive 𝑅2𝐶𝑆𝑂𝑆  and significant. Moreover, we measure the economic value of the cross-sectional model by constructing the value- and equal-weighted long-short portfolios based on the estimated returns of the SOLS model. We find that both the value- and equal-weighted long-short portfolios generate a sizable monthly profit, much higher than the simple market portfolio returns. Lastly, we show that the four well-known determinants of cross-sectional stock returns (momentum, market capitalization, book-to-market ratio, operating profit, and investment) fail to explain the cross-sectional determinant captured by the technical indicators.

In short, the technical indicators added value and enhanced portfolio performance.

References

[1] Zeng, Hui and Marshall, Ben R. and Nguyen, Nhut H. and Visaltanachoti, Nuttawat, Technical Indicators and Cross-Sectional Expected Returns (2021). https://ssrn.com/abstract=3992035

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