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Price trends and patterns in technical analysis: A theoretical and empirical examination

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  • Friesen, Geoffrey C.
  • Weller, Paul A.
  • Dunham, Lee M.
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    Abstract

    While many technical trading rules are based upon patterns in asset prices, we lack convincing explanations of how and why these patterns arise, and why trading rules based on technical analysis are profitable. This paper provides a model that explains the success of certain trading rules that are based on patterns in past prices. We point to the importance of confirmation bias, which has been shown to play a key role in other types of decision making. Traders who acquire information and trade on the basis of that information tend to bias their interpretation of subsequent information in the direction of their original view. This produces autocorrelations and patterns of price movement that can predict future prices, such as the "head-and-shoulders" and "double-top" patterns. The model also predicts that sequential price jumps for a particular stock will be positively autocorrelated. We test this prediction and find that jumps exhibit statistically and economically significant positive autocorrelations.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 33 (2009)
    Issue (Month): 6 (June)
    Pages: 1089-1100

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    Handle: RePEc:eee:jbfina:v:33:y:2009:i:6:p:1089-1100

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Technical analysis Head-and-shoulders Trading rules Confirmation bias Jump autocorrelations;

    References

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    Cited by:
    1. Menkhoff, Lukas, 2010. "The Use of Technical Analysis by Fund Managers: International Evidence," Hannover Economic Papers (HEP) dp-446, Leibniz Universit├Ąt Hannover, Wirtschaftswissenschaftliche Fakult├Ąt.
    2. Klaus Grobys, 2012. "Active PortofolioManagement in the Presence of Regime Switching: What Are the Benefits of Defensive Asset Allocation Strategies If the Investor Faces Bear Markets?," The Review of Finance and Banking, Academia de Studii Economice din Bucuresti, Romania / Facultatea de Finante, Asigurari, Banci si Burse de Valori / Catedra de Finante, vol. 4(1), pages 015-031, June.
    3. Andrew Clare & James Seaton & Peter N. Smith & Stephen Thomas, 2013. "The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation," CAMA Working Papers 2013-24, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    4. Huang, Weihong & Zheng, Huanhuan, 2012. "Financial crises and regime-dependent dynamics," Journal of Economic Behavior & Organization, Elsevier, vol. 82(2), pages 445-461.
    5. Taylor, Nick, 2014. "The rise and fall of technical trading rule success," Journal of Banking & Finance, Elsevier, vol. 40(C), pages 286-302.
    6. Serban, Alina F., 2010. "Combining mean reversion and momentum trading strategies in foreign exchange markets," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2720-2727, November.

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