Trading Rules and Market Efficiency

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Trading Rules and Market Efficiency

• Fin250f Lecture 4.3
• Fall 2005
• Reading Taylor, chapter 7

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Outline

• Moving average rules
• Channel rules
• Filter rules
• Rule evaluation
• Statistical significance and risk
• Breakeven transaction costs
• Monte-carlo and bootstrap tests

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Moving Average Trading Rules (Simplest)
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Multiple Averages
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Bands
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Channel Rule
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Channel Rule
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Filter Rule

• Buy period to sell
• Price falls by f fraction from recent price max
• Sell period to buy
• Price rises by f fraction from recent price min

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Rule Evaluation

• Statistical significance
• Breakeven transaction costs
• Risk

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Significance Test I Buy-Sell
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Significance Test II Dynamic strategy,
genmatrule.m
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Probability of a Price Rise
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Results From Equity Markets

• Brock, Lakonishok, LeBaron(1992)
• Dow data (daily/100 years)
• Standard MA rules (5, 50, 150, 200 day)
• Stat sig predictability
• Volatility forecasts
• Sullivan, Timmermann and White(1999),
  LeBaron(2000)
• Results drop in 90s
• Day and Wang(2002)
• Nonsynchronous prices

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Global Equity Markets

• Bessembinder and Chen(1995)
• Repeat results for Asia
• Hudson, Dempsey, and Keasey(1996)
• Long range results form UK
• Consistent predictability over many years, many
  countries
• Predictability falling over time

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FX Markets

• Generally stronger predictability than equity
  markets
• Levich and Thomas(1993)
• LeBaron(1992)
• Some connections with intervention
• LeBaron(1999)

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Transaction Costs

• Costs of trading Important
• Often assume proportional
• Depends on strategy
• First strategy
• Simple (Long/short) futures
• Long in buy periods
• Short in sell periods

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Transaction Costs I. Simple long/short futures
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Breakeven Transaction Costs Simple long/short
futures
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Transaction Costs Simple Equity Strategy

• Equity strategy
• Sell Hold risk free
• Buy Leverage position
• Invest own 1, borrow additional 1
• Designed to replicate risk on buy and hold

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Transaction costs Equity strategy
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Breakeven Transaction Costs Equity portfolio
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Results

• US equity(Dow) 0.22 for recent periods
• Smaller than most T-cost estimates
• Older periods (up to 1)
• Currencies large returns for 0.2 transaction
  levels (6-10) (Sharpe ratios near 1)
• All near zero beta

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Recent Results

• All trading rule returns falling in the 1990s
• Increased efficiency?
• LeBaron(1999) FX interventions
• Removing intervention period removes most fx
  predictability
• Few US interventions in the 90s

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Evidence Summary

• Generally large statistical significance
• Marginal break even results
• Except FX
• Big returns after T-costs
• Good risk tradeoff
• Careful All results getting smaller over all
  recent periods!!!!

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Bootstrap Tests

• Brock, Lakonishok, and LeBaron(1999)
• Scrambled returns series
• (Monte-carlo simulated normal returns)
• Destroy patterns
• Evaluate rules on scrambled series
• Compare with original
• Matlab
• bsmarule.m

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Extensions

• Fancier rules
• Better positions
• Pattern recognition systems
• Changing position sizes based on various signals
• More advanced risk measures