Technical Trading in the Foreign Exchange Market

Technical trading is a method of analyzing securities by studying past price movements and trends. Based on this analysis, traders then make decisions about what trades to make. Technical traders use indicators to develop algorithmic trading systems. These trading systems are popular in the equity and commodity futures markets.

Reference [1] examined technical trading rules in the foreign exchange market. It pointed out,

In this paper we have replicated a comprehensive range of technical trading rules which have previously been shown to generate high returns in currency markets, focusing on the most liquid currencies, over an out-of-sample period up to April 2020. We find diminishing evidence of performance out-of-sample. In-sample we find that each of the rules generate large and statistically significant risk-adjusted returns, in line with the existing literature. Out-of-sample the performance dissipates gross of transaction costs and disappears when costs are accounted for. None of the four rules we analysed generates meaningful performance and none of their Sharpe ratios are statistically significant.

In short, technical trading in the FX market does not perform well. The authors also uncovered a relationship between technical trading and momentum,

Most importantly, we document the strong link between technical trading rules and time series momentum. Using PCA, regression and portfolio analyses we show that time series momentum fully explains all of the returns to technical trading rules. When we decompose our sample period into months when time series momentum returns are positive and negative, we see that the returns to technical trading rules are generated in periods when momentum is successful.

We agree that a trade is a bet on the dynamics of the underlying asset. In other words, if the underlying asset is trending, then trend-following trading systems will do well and vice versa. Technical indicators are just an aid to help traders extract profit. However, we think that their first conclusion is too strong. Is it possible to use technical trading rules to capture profit when the momentum is negative? This can be achieved, for example, by using mean-reverting trading systems instead of trend-following ones.

Let us know your thoughts in the comments below.

References

[1] Hutchinson, Mark C. and Kyziropoulos, Panagiotis and O’Brien, John and O’Reilli, Philip and Sharma, Tripti, Technical Trading Rule Profitability in Currencies: It’s All About Momentum (2022). https://ssrn.com/abstract=4024310

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