How Accurate are Technical Indicators?

A technical trading system is a set of rules that define how to enter, exit, and manage trades in the financial markets. It is based on technical analysis which seeks to identify trends and patterns by analyzing past price movements. It includes precise criteria for when to buy or sell securities as well as clear guidelines for managing positions once opened.  A successful system should be able to adapt to changing market conditions and provide an edge over the average trader.

Technical trading systems make use of technical indicators which are mathematical calculations based on price, volume, and other market data. These indicators measure the strength or weakness of an asset as well as possible trends in the market. Examples of technical indicators include moving averages, relative strength index (RSI), and money flow index (MFI).

Reference [1] examined how accurate the technical indicators are and their connection with market volatility. Specifically, it studied the accuracy of the so-called Price Deviation from Moving Average (PDMA) indicator which is defined as the difference between the Log current price and the Log moving average price over a given period. The authors pointed out,

…we investigate the information of the technical indicator (PDMA) on volatility in the next trading day for 8 stock indexes, where the volatility is measured by daily realized volatility. We first propose the static and dynamic copulas to model the impact by using tail dependence parameters to measure the amount of the information…The empirical analysis results imply that although there is some distinction in the estimated results between each stock index, the PDMAs are significantly informative on the next day volatility at extreme markets, while are less informative at normal markets for 8 indexes considered. We also find that: 1) The amount of information is asymmetric significantly in most case; 2) The information from positive PDMA will fade away, and that from negative one will enhance, as given horizons of PDMA increase in Europe and America cases; 3) There are some distinct differences between emerging market indexes and developed market indexes in the information contents. Moreover the information contents are found to be changing over time in a highly persistent manner.

In short, the PDMA indicator is accurate in predicting future volatility under a volatile market condition. In more normal market conditions, it’s less accurate.

This finding confirmed again that traders should employ market regime filters in their trading systems.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Yafeng Shi , Xiangxing Tao , Yanlong Shi , Nenghui Zhu , Tingting Ying, and Xun Peng, Can Technical Indicators Provide Information for Future Volatility: International Evidence, Journal of Systems Science and Information, Feb., 2020, Vol. 8, No. 1, pp. 53–66

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