METHODICAL MADNESS: WHY TECHNICAL TRADING IS A BAD STRATEGY IN FOREIGN EXCHANGE MARKETS
The ubiquitous practice of technical trading in the foreign exchange market, where positions are taken on the basis of patterns in past prices and trading volumes, seems to make little sense as a trading strategy. According to Professor Carol Osler and Dr Kevin Chang, writing in the latest issue of the Economic Journal, using the ‘head-and-shoulders pattern’, a popular chart configuration that technical analysts consider particularly reliable as an indicator of future exchange rate trends, is often unprofitable and almost always generates forecasts that could be easily improved by simple alternative strategies.

The researchers have analysed the head-and-shoulders technique for six currencies against the US dollar over the period 1973-94: the Japanese yen, German mark, Canadian dollar, Swiss franc, French franc, and UK pound - For four of the six currencies - the pound, French and Swiss francs, and Canadian dollar - trading on head-and-shoulders patterns failed to generate statistically significant profits. In all of these cases, traders were not behaving rationally since they could have done at least as well by using a forecast of ‘no change’ - that is, by assuming that the exchange rate would be the same tomorrow as it is today.

For the mark and the yen, trading based on head-and-shoulders patterns produced statistically significant profits that were large even when adjusted for risk, opportunity costs, and transactions costs. So forecasts based on the pattern did better than the assumption of no change. But these forecasts were still not rational, since a simple alternative approach did much better. In particular, basic trend-following strategies, like those based on moving-average cross-overs, produced far higher profits with less risk. Indeed, the researchers find, head-and-shoulders patterns were not useful even as a secondary signal to corroborate signals from the simpler strategies

It is estimated that over 90% of the participants in the huge foreign exchange markets in London and Hong Kong rely on technical strategies. As the diagram above illustrates, the ‘head-and-shoulders pattern’ that so many of them use comprises a sequence of three peaks with the highest in the middle. The left and right peaks are the shoulders, the centre peak is the head and the straight line connecting the troughs on either side of the head is called the neckline. The pattern is said to be completed when the price path crosses the neckline after forming the right shoulder. The head-and-shoulders pattern can occur at peaks and at troughs, and according to the technical analysts, such patterns precede trend reversals and can be used profitably as a trading signal.

The researchers chose to concentrate their study on currency traders because of the high liquidity of these markets, the low bid-ask spreads, and the round the clock decentralised trading. But technical analysts claim that the principles that underlie the analysis of currencies from a technical aspect are basically the same as those used in any other financial market. This has worrying implications for the practice of technical analysis as a whole, not just in the foreign exchange market.

Note for Editors: ‘Methodical Madness: Technical Analysis and the Irrationality of Exchange-Rate Forecasts’ by Kevin Chang and Carol Osler is published in the October 1999 issue of the Economic Journal. Chang is at Credit Suisse First Boston; Osler at the Federal Reserve Bank of New York.

For Further information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 0468-661095 (email: romesh@compuserve.com); RES Media Assistant Niall Flynn on 0171-878-2919 (email: nflynn@cepr.org); or Carol Osler via email: carol.osler@ny.frb.org.