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Currency Forecasting Using Technical Analysis

No other forecasting tool has come under more academic


scrutiny than technical analysis
Technical analysis involves the study of past price
behavior
The rationale is that if financial asset prices move in trends
then trend following trading rules can be used to predict
future trends in asset prices

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical


Analysis
Extremely Popular among traders
Most fund managers and traders utilize some form of
technical analysis, particularly over short time horizons
Dissatisfaction of currency traders and fund managers over
the use of fundamental and economic models of exchange
rate determination

Currency Forecasting Using Technical Analysis


Swings in exchange rates since 1971 have been greater
than expected, frequently overshooting the intrinsic
equilibrium levels of fundamental-based models such as
PPP, Monetary and Balance of Payments Method of FX
rate determination
When exchange rates overshoot their intrinsic equilibrium
level, fundamental based forecasts may prematurely
recommend that positions be reversed as the models
intrinsic equilibrium is breached

Currency Forecasting Using Technical Analysis


Technical Analysis has a clear advantage over fundamental
based models when exchange rates swing unexpectedly
and in large % terms
Technical models are designed to keep an investor trading
with and not against the trend
Technical traders are not concerned with the true value of
the currency but what the market perceives as the Market
Value

Currency Forecasting Using Technical Analysis


Curcio and Goodhart Study (1993)
The research suggests that to control short-term FX
risk many market participants have gravitated from
fundamental analysis to technical analysis
Students at the London School of Economics (LSE)
were separated into two groups. One group used
fundamental analysis and the other used technical analysis.
The performance of the two groups were roughly the same.

Curcio and Goodhart Study


The standard deviation of the the group using technical
analysis was considerably smaller than for the group using
fundamental analysis
The fundamental group without the aid of technical analysis
followed extreme contrarian strategies and magnified the
volatility of their returns
By following technical analysis the students in the Technical
Analysis group avoided extreme contrarian

Conclusion: Technical based trading strategies in


FX proved useful for controlling risk even though it
did not result in improved mean returns.

Currency Forecasting Using Technical Analysis


The Group of 30 Study (1985)
Participants were questioned whether they believed the use
of technical analysis had a significant impact on the trend
of FX rates
97% responded Yes

The G-30 Study


Respondents believed that the use of technical analysis
models had a marked impact by making the FX market
more volatile and by exacerbating trends in exchange
rates.

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate
Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


Allen and Taylor Study (1989)
90% of all FX dealers surveyed in the London FX
market used some form of technical analysis to help them
formulate their outlook for FX rates over short periods of
time, especially for intraday and one-week time horizons.
Over longer periods of time the dealers surveyed used
technical analysis to a smaller degree and used
fundamental analysis more.
This study substantiates the research hypothesis in last
weeks lecture.

Currency Forecasting Using Technical Analysis


Considerable Scorn in Academic Circles
Efficient Market Hypothesis (EMH) suggests that technical
analysis is useless
Empirical Evidence suggests the contrary

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


Disputing The Efficient Market Hypothesis
Fundamental Forecasts require independent projections of
underlying economic variables that determine exchange
rates
Investor who uses technical analysis finds him/her
trading with the trend and not against it
Trend following models do not attempt to catch the
very top or bottom of the market. Instead the models
are designed to capture enough of a market move in
in the hope of catching a sizable profit

Currency Forecasting Using Technical Analysis


All technical analysis models have one thing in common
They seek to identify which direction the broad trend in market
places are heading
Primary waves are large broad moves in market prices that
carry the underlying trend in market prices whether up or down
Secondary waves are temporary corrections or partial retracements of the primary trend over a full cycle
Trend following models attempt to identify the direction of the
primary wave

Currency Forecasting Using Technical Analysis


Uptrends indicate advancing prices by successfully higher
peaks
Downtrends will be indicated when declining prices
establish successfully lower troughs and when intervening
advances fail to rise above preceding peaks
In a rising market each rally and partial retrenchment will
be higher than its predecessor
When the wave-like series of rising peaks and troughs is
broken a reversal in market trend is signaled

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


To identify and confirm the existence of a trend the
Technical Analyst will use a trend line under (above) the
successive partial retracements of the troughs or peaks.
The more times the market prices touch the trend line
without violating it, the more confident the technical
analyst will be that the prevailing trend will continue

Currency Forecasting Using Technical Analysis


The violation of a valid uptrendline is a signal that the pace
of advance will be altered in the future.
If there is a failure of market prices to rise above the
previous highs and a tendency for intervening price
declines to fall below their preceding troughs, a confirmed
reversal would be signaled
Markets reverse in many ways but all reversals must be
preceded by the failure of market prices to achieve
successfully higher peaks and troughs

Currency Forecasting Using Technical Analysis


Head and Shoulders Patterns

One of the most recognizable patterns of market peaks and


troughs is the head and shoulders pattern
A head and shoulders reversal pattern is essentially a series
of three successive rallies with the second stronger than the
first and the third weaker than the second
Initial indicator of weak demand

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Source: Currency Forecasting: A Guide to Fundamental and


Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


Continuation Patterns
Price Action that does not end in successfully higher peaks
and troughs is viewed as consolidation or a continuous
pattern

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


Computer Generated and Computer Interpreted Models
Sophisticated techniques subject to less human error
Filter Rule
Buy recommendations if exchange rates rise x % above their most
recent trough and sell recommendations if exchange rates fall x %
below their most recent peak

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


Crossover Strategies
Constructed to smooth the erratic movements of daily
exchange rates so that the primary trend in exchange rates
can be isolated
An advance of the short-run average above the long-run
moving average is seen as an indication of buying strength
and vice versa

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Source: Currency Forecasting: A Guide to Fundamental


and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


Extrapolation and Lag
All trend following techniques use extrapolation
All trend following techniques have a lag effect
Lag effects are not pronounced when FX rate swings are sustained
Lag effects are pronounced in a trend less environment and
whipsaws and false signals will occur

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Currency Forecasting Using Technical Analysis


Technical models are able to correctly predict trends 50%
of the time (Schulmeister, 1987)
Profits are allowed to ride when the markets are up trended
while losses are taken quickly when whipsaws occurred

Currency Forecasting Using Technical Analysis


Momentum
Momentum usually confirms the trend
Rising prices occur with increasing velocity
With rising momentum the odds are that the trend will
continue
However if prices are rising with decreasing momentum it
may be a sign of weakness in a prevailing trend
Overbought or Oversold conditions
Useful warning signs

Source: Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination
By: Michael R. Rosenberg

Source: Currency Forecasting: A Guide to


Fundamental and Technical Models of Exchange
Rate Determination
By: Michael R. Rosenberg