A brief (10 minute) presentation on my thesis "Profitability of automated technical trading strategies in the foreign exchange market". Presented as part of the CSULB student research competition on 2/25/11

1. Brian Leip Profitability of automated technical trading systems in the foreign exchange market College of Business Administration Finance Major, CBA Honors Program Supervisor: Dr. Pamela Miles Homer

2. OUTLINE Purpose of the Study Introduction Background and Literature Review Methodology Hypotheses Results

3. PURPOSE OF THE STUDY Examine the profitability of 63 publicly available Technical Trading Systems (TTS) Which systems work the best and why? Currency pairs Technical indicators Exit technique Complexity/sophistication

4. PURPOSE OF THE STUDY Expand the understanding of Technical Analysis Technical analysis - “the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends” (Murphy, 1999) TA historically disregarded by academia due to its conflict with the efficient market hypothesis (EMH) Sparse coverage of TA at the college level TA is widely used by practitioners creating a large gap between “the classroom” and “the street”

5. INTRODUCTION – Efficient Market Hypothesis (EMH) What is the Efficient Market Hypothesis (EMH)? Dominant paradigm in financial theory from the 60s to the 90s Markets created by hyper-rational decision makers No one can beat the market except by luck or by taking on risk Therefore TA and FA should not work

6. INTRODUCTION – Efficient Market Hypothesis (EMH) Prominent Critics Warren Buffett - Investor John Maynard Keynes – Economist Robert Haugen – Professor at UC Irvine Paul McCulley – Managing director at PIMCO The field of behavioral finance All practitioners using fundamental and/or technical analysis Universities now expanding beyond EMH but still very few classes on Technical Analysis Skepticism of TA slow to change

7. INTRODUCTION – Technical Analysis Purpose of Technical Analysis To capitalize on market inefficiencies (e.g. trends) Types of TA Methods Qualitative – Charting (pattern finding) Quantitative – Technical indicators, trading systems Used in this study

8. INTRODUCTION – Technical Analysis Tenets of Technical Analysis Market action (price and volume data) efficiently summarizes all microeconomic, macroeconomic and behavioral information Prices move in trends History repeats itself

9. INTRODUCTION – Chart with Technical Indicators

10. INTRODUCTION – The Foreign Exchange Market Floating Rate Foreign Exchange Market Also called forex or FX market Began in early 70s All currencies are quoted in relation to another EURUSD = Price of the Euro in relation to the US Dollar To buy one currency you must also sell another Daily turnover = 2 trillion USD Several times greater than all stock exchanges in the world combined TA used extensively in forex market

12. Taylor and Allen (1992)

13. 90% of UK forex respondents use some form of TA

14. Cheung & Chinn (2001)

15. 30% of US forex market practitioners would best describe themselves as TA tradersSource: Cheung & Chinn (2001)

16. BACKGROUND AND LITERATURE REVIEW Early Studies – TA in the Stock Market (60s & 70s) Widely cited studies from the 60s find TA to be unprofitable Fama and Blume (1966) Van Horne and Parker (1967, 1968) Jensen and Benington (1970) Fama declares TA to be a futile undertaking (1970) Note: Fama is the founder of the Efficient Market Hypothesis

17. BACKGROUND AND LITERATURE REVIEW Early Studies – TA in the Forex Market (60s, 70s & 80s) In contrast, TA studies in FX market generally found sizable net profits Poole (1967) Dooley and Shafer (1976) Logue and Sweeney (1977) Logue, Sweeney and Willett (1978) Cornell and Dietrich (1978) Dooley and Shafer (1983) Sweeney (1986) Schulmeister (1987) Shortcomings in study methodologies

18. BACKGROUND AND LITERATURE REVIEW Modern Studies Address shortcomings found in early studies Mixed results on profitability 56 of 95 (59%) - positive returns 20 of 95 (21%) - negative returns 19 of 95 (20%) – mixed results Source: Park, Irwin (2007)

19. BACKGROUND AND LITERATURE REVIEW Survey of literature for TA in forex market Menkhoff, Taylor (2007) Review of 44 academic studies Conclusion Beyond question that TA may be used to provide very high returns TA is an intrinsic part of the forex market For researchers, this means TA must be understood and integrated into economic reasoning For practitioners, TA strategies must be constantly evaluated as potentially important tools

20. METHODOLOGY What makes my study unique? Number of Technical Trading Systems – 63 To my knowledge, 23 is the max in other studies Time frame 1975 – 2010 (35 years) Results geared towards finding the best technical trading systems rather than refuting EMH

21. METHODOLOGY Select target market [forex], vehicles [7 major currency pairs] and time frame [daily] Gather publicly available trading strategies [63 total] Common usage Ammermann, Conceicao (2010) CSULB Finance Professor and CSULB Alum Bollinger (2002) Elder (1993) Katz (2000) Leip (2010) Systems and indicators I created Murphy (1999) Pruitt, Hill (2003)

22. METHODOLOGY Program the 63 Strategies into TradeStation

23. METHODOLOGY Bifurcate the available data and run optimizations on recent ½ (in-sample) to generate optimal inputs for the strategy 63 strategies * 7 currency pairs = 441 optimizations 69,030 average tests * 441 = 30,442,230 total tests

24. METHODOLOGY Organize the results and apply a scoring metric to all tests Select the top performing test from each of the 441 optimizations. Apply to the older ½ of the data (out-of-sample) and save results Gather the 441 out-of-sample results and analyze

25. METHODOLOGY TradeStation Software Platform Gold standard for rule based trading Expensive - $100/month Recipient of numerous awards

26. HYPOTHESES H1 –Technical Trading Systems will have out-of-sample excess profits that cannot be accounted for by the bearing of risk H2 – The more complex Technical Trading Systems will outperform less complex ones Excess profit test Sharpe Ratio – Calculates excess returns over the risk free rate

27. RESULTS Avg. Sharpe Ratio by Strategy

28. RESULTS Avg Sharpe Ratio by Complexity (1=simple, 5=complex)

29. HYPOTHESES – Expected Results H1 – Sharpe ratios indicate that Technical Trading Systems have out-of-sample excess profits that cannot be accounted for by the bearing of risk H2 – Sharpe ratios indicate a clear link between excess risk adjusted returns and complexity

30. APPENDIX - RESULTS Avg. Sharpe Ratio by Currency

31. APPENDIX - RESULTS Avg. Sharpe Ratio by Technical Indicator

32. APPENDIX - RESULTS Avg. Sharpe Ratio by Exit Type

33. APPENDIX - RESULTS Avg. Sharpe Ratio by Source

34. Question & Answer Thank you for your time