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Technical trading patterns: can they truly predict price movements and can they be exploited for excess returns?

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  • Ajwa, Martine Therese

Abstract

Debate exists in financial markets over whether patterns exist in stock prices which can be used to predict future prices and to earn excess returns. Proponents of this idea, technical traders, view stock prices as following trends and exhibiting consistent patterns which can be exploited for gain. Fundamental analysts, however, believe that stock prices change only in response to the arrival of information which occurs randomly and does not generate any predictable patterns in stock prices. To fundamental analysts, consistent profit can only be gained if investors have access to information before everyone else and if they can correctly infer the effect of the news on market prices;Therefore, the question arises which view of the markets is more accurate. In an attempt to answer this question, this work will be separated into two parts. The first part will ask if predictable patterns in stock prices exist as technical traders surmise, or if these patterns are spurious as fundamental analysts would hypothesize. The second part will ask if profit can be consistently made according to the technical traders' rules for pattern trading, or if these profits are inconsistent;To evaluate the first part, this work uses a Monte Carlo experiment to compare the number of times three technical trading patterns are found in four actual stock price series to the number of times these patterns are found in randomly-generated series chosen to mimic the actual stock series. The evidence shows that we cannot reject the hypothesis that these patterns occur as frequently in the random series as they occur in the actual stock series. This finding contradicts the beliefs of technical traders;To evaluate the second part, this work calculates the returns gained from following technical trading rules regarding the patterns. Total profit is calculated for each stock price series and each pattern assuming an investment of 1 million and each trading rule exploited. The evidence shows that we cannot reject the hypothesis that average returns from these trading rules are zero.

Suggested Citation

  • Ajwa, Martine Therese, 1995. "Technical trading patterns: can they truly predict price movements and can they be exploited for excess returns?," ISU General Staff Papers 1995010108000011754, Iowa State University, Department of Economics.
    • Handle: RePEc:isu:genstf:1995010108000011754
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