Perry J. Kaufman has over thirty years of experience inthe equity and derivatives markets. A prominent expert onsystematic trading, he travels internationally, lecturing to funds,governments, and portfolio managers. He began his career in theaerospace industry, working on the navigation and control systemsof the Gemini space program. The markets captured hisattention in the early 1970s, and he was one of the first todevelop computer models for making market decisions. Kaufmandeveloped a portfolio optimization program that operates ondisjoint equity series output from a trading environment. He hascreated market-neutral strategies, stat-arb trading methods,short-term program trading for cash, and derivative marketinstruments for institutional and commercial applications. Kaufmanwas the first chairman of the advisory board of the VermontSecurities Institute, and has served on the Director's Committee ofColumbia University's Center for the Study of Futures Markets,founding the Journal of Futures Markets. In 2002, he taughta landmark course in systematic trading at the graduate school ofBaruch College. Perry Kaufman is the author of several populartrading books including A Short Course in Technical Tradingand Alpha Trading.
It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change.
Let's start by redefining the term technical analysis. Technical analysis is the systematic evaluation of price, volume, breadth, and open interest, for the purpose of price forecasting. A systematic approach may simply use a bar chart and a ruler, or it may use all the calculation power available. Technical analysis may include any quantitative analysis as well as all forms of pattern recognition. Its objective is to decide, in advance, where prices will go over some time period, whether 1 hour, 1 day, or 5 years. Technical analysis must have clear and complete rules.
Technical analysis is no longer just the study of chart patterns or the identification of trends. It encompasses intramarket analysis, complex indicators, mean reversion, and the evaluation of test results. It can use a simple moving average or a neural network to forecast price moves. This book serves as a reference guide for all of these techniques, puts them in some order, and explains the functional similarities and differences for the purpose of trading. It includes some aspects of portfolio construction and multilevel risk control, which are integral parts of successful trading.
THE EXPANDING ROLE OF TECHNICAL ANALYSIS
Quantitative methods for evaluating price movement and making trading decisions have become a dominant part of market analysis. Those who do not use methods such as overbought and oversold indicators are most likely to watch them along the bottom of their screen. The major financial networks are always pointing out price trends and double bottoms, and are quick to say that a price move up or down was done on low volume to show that it might be unreliable. The 200-day moving average seems to be the benchmark for trend direction. These comments show the simplicity and the acceptance of technical analysis.
Events beginning in 2002 cast doubt on the integrity of the research produced by major financial houses that have a conflict between financing/underwriting and retail brokerage. The collapse of Enron has caused us to question the earnings, debt, quality-of-business, and other company data released to the public by large and small firms. It is not surprising that more quantitative trading methods have been adopted by research firms. When decisions are made with clear rules and calculations that can be audited, those analysts recommending buys and sells are safe from scrutiny.
Extensive quantitative trading exists around the world. Interest rate arbitrage is a major source of revenue for banks. Location arbitrage is the process that keeps the price of gold and other precious metals the same all over the globe. Program trading keeps the price of the overall stock market from diverging from S&P futures and SPY (the SPDR ETF) prices. Recently these fully automated systems have been called algorithmic trading.
If you don't think of arbitrage as technical trading, then consider market neutral strategies, where long and short positions are taken in related markets (pairs trading) in order to profit from one stock rising or falling faster than the other. If you change your time horizon from hours and days to milliseconds, you have high frequency trading. You might prefer to take advantage of the seasonality in the airline industry or try your hand trading soybeans. Both have clear seasonal patterns as well as years when other factors (such as a disruption in energy supply) overwhelm the seasonal factors. Trading seasonal patterns falls under technical analysis.
Technology that allows you to scan and sort thousands of stocks, looking for key attributes-such as high momentum, a recent breakout, or other indicator values-is also technical analysis on a broader scale. High frequency trading, arbitrage that lasts only milliseconds, has become a profit center for large financial institutions, but involves placing computer equipment as close to the source of the exchange price transmission as possible-a contentious issue. High frequency trading is credited for adding liquidity by increasing volume in equities trading, but has also been blamed (perhaps unfairly) for spectacular, highly volatility price moves.
Most impressive is the increase in managed funds that use technical and quantitative analysis. Many billions of investment dollars are traded using trend-following systems, short-term timing, mean reversion, and countless other techniques. It is thought that well over half of all managed money uses algorithmic trading. Technical analysis allows you to backtest and estimate the expected risk, two great advantages to the fund manager. The use of technical analysis has infiltrated even the most guarded fundamental fortresses.
CONVERGENCE OF TRADING STYLES IN STOCKS AND FUTURES
The development of technical analysis has taken a different path for stocks and futures. This seems natural because the two markets cater to investors with different time frames and different commercial interests. At the same time, the markets place very different financial demands on the investor.
The original users of the futures markets were grain elevators and grain processors, representing the supply side and the demand side. The elevators are the grain wholesalers who bought from the farmers and sold to the processors. The futures markets represented the fair price, and grain elevators sold their inventory on the Chicago Board of Trade in order to lock in a price (hopefully a profit). The processors, typically bread manufacturers or meat packers, used the futures markets to lock in a low price for their material cost and as a substitute for holding inventory. Both producer (the sell side) and processor (the buy side) only planned to hold the position for a few weeks or a few months, until they either delivered their product to market or purchased physical inventory for production. There was no long-term investment, simply a hedge against risk. Futures contracts, similar to stock options, expire every two or three months and can be held for about one year; therefore, it is nearly impossible to "invest" in futures.
One other critical difference between futures and stocks is the leverage available in futures. When a processor buys one contract of wheat, that processor puts up a good faith deposit of about 5% of the value of the contract. If wheat is selling for $10.00 a bushel and a standard contract is for 5,000 bushels, the contract value is $50,000. The processor need only deposit $2500 with the broker. The processor is essentially buying with leverage of 20:1.
In the 1970s, the futures trader paid an outrageous round-turn commission of $50 per contract. This is about 0.3 of 1 percent, far less than the stock market cost of 1%, but one of the highest commission ratios in the futures industry. Now, years after negotiated commissions have become part of the system, the fee is closer to $8, or 0.05 of one percent. Commission costs are so low that they are not a consideration when trading futures. To be fair, the cost of trading equities has also dropped in the same way, but favors those trading larger positions.
How do the high leverage and low commissions affect trading in futures? Low costs allow short holding periods. Floor traders don't invest-they look to scalp the market or capture a fast, volatile price move. In the derivatives markets, fast is 1 to 3 days, and slow is anything longer than 30 days.
Although speculation has always had a place in the stock market, the investor, rather than the trader, has been the major force. The stock market is an investment in America. The growth of the economy parallels the growth and efficiency of industry. Of course, commissions and tax regulations played a large part in shaping the long-term view of the investor. When commission costs were 1% for each buy and sell order, it was not possible to be a short-term trader. That role was reserved for the market maker on the floor of the stock exchange. It is difficult to be a trader of any sort when you pare 2% from each of your trades. Even now, some mutual funds charge high fees or penalties for liquidating a position before six months or one year. In addition, favorable tax treatment strongly encouraged holding positions for at least six months to satisfy the long-term capital gain rule. The uptick rule for selling discouraged speculating on the decline of stock prices, and while it is not in effect at this time, politicians are inclined to reinstate it in the belief that it will reduce market volatility. Even now, short sales are not allowed in most retirement funds. To get around these rules, exchange-traded funds (ETFs) such as SPY and QQQ allow buying and short selling with no expiration date and low cost. The main differences between trading ETFs and futures is that futures allow leverage, trade in larger size, expire at fixed intervals, and are guaranteed by a major institution, such as the Chicago Mercantile Exchange. Because of the low cost in stocks and the new trading vehicles in the form of ETFs, stock traders now look to the methods used by futures traders to identify trends and mean-reverting opportunities faster and use tighter risk controls.
A LINE IN THE SAND BETWEEN FUNDAMENTALS AND TECHNICAL ANALYSIS
The market is driven by fundamentals. These are often employment, GDP, inflation, consumer confidence, supply and demand, or geopolitical factors-all of which create expectations of price movement. But it is just too difficult to trade using...