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Z. K. Silagadze Budker Institute of Nuclear Physics and Novosibirsk State University, 630 090, Novosibirsk, Russia

arXiv:0802.0984v1 [physics.soc-ph] 7 Feb 2008

Abstract

We propose a new indicator for technical analysis. The indicator emphasizes maximums and minimums in price series with inherent smoothing and has a potential to be useful in both mechanical trading rules and chart pattern analysis.

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INTRODUCTION

Despite the widespread use of technical analysis in short-term marketing strategies, its usefulness is often questioned. According to the eﬃcient market hypothesis [1], no one can ever outperform the market and earn excess returns by using only the information that the market already knows. Therefore, technical analysis, which is based on the price history only, is expected to be of the same value for eﬃcient markets as astrology: “Technical strategies are usually amusing, often comforting, but of no real value” [2]. However, the eﬃcient market hypothesis assumes that all market participants are rational, while it is a well known fact that human behavior is seldom completely rational. Therefore, the idea that one can try “to forecast future price movements on the assumption that crowd psychology moves between panic, fear, and pessimism on one hand and conﬁdence, excessive optimism, and greed on the other” [3] does not seem to be completely hopeless. At least, “by the start of the twenty-ﬁrst century, the intellectual dominance of the eﬃcient market hypothesis had become far less universal. Many ﬁnancial economists and statisticians began to believe that stock prices are at least partially predictable” [4]. Besides, the market eﬃciency can be signiﬁcantly distorted at periods of central bank interventions which allow traders to proﬁt by using even very simple technical trading rules at these periods [5, 6]. Anyway the use of technical analysis is widespread among practitioners, becoming in fact one of the invisible forces shaping the market. For example, many successful ﬁnancial forecasting methods seem to be self-destructive [4, 7]: their initial eﬃciency disappears once these methods become popular and shift the market to a new equilibrium. The technical analysis is based on the supposition that asset prices move in trends and that “trends in motion tend to remain in motion unless acted upon by another force” (the analogue of the Newton’s ﬁrst law of motion) [8]. The ﬁnancial forces that compel the trend to change are subject of fundamental analysis [9]. Eﬃcient markets react quickly to various volatile fundamental factors and to the spread of the corresponding information leaving little chance to practitioners of either technical or fundamental analysis to beat the market. However, real markets react with some delay (inertia) to changing ﬁnancial conditions [10] and trends in these transition periods can reveal some characteristic behavior determined by human psychology and corresponding irrational expectations of traders. A skilled analyst 2

can detect these characteristic features with tools of technical analysis alone (although some fundamental analysis, of course, might be also helpful and reduce risks). Practitioners of the technical analysis often use charting (graphing the history of prices over some time period) to identify trends and forecast their future behavior [3, 8, 11, 12]. At that peaks and and troughs in the price series play important role. Location of such local maximums and minimums is hampered by short-term noise in the price series and usually some smoothing procedures are ﬁrst applied to remove or reduce this noise. Below an algorithm for searching of local maximums and minimums is presented. The algorithm is borrowed from nuclear physics and it enjoys an inherent smoothing property. A new indicator of technical analysis, the moving mini-max, can be based on this algorithm.

THE IDEA BEHIND THE INDICATOR

The idea behind the proposed algorithm can be traced back to George Gamow’s theory of alpha decay [13]. The alpha particle is trapped in a potential well by the nucleus and classically has no chance to escape. However, according to quantum mechanics it has nonzero, albeit tiny, probability of tunneling through the barrier and thus to escape the nucleus. Now imagine a small ball placed on the edge of the irregular potential well (see Fig.1). Classical ball will not roll down stopping in front of the foremost obstacle. However, if the ball is quantum, so that it can penetrate through narrow potential barriers, it will still ﬁnd its way towards the potential well bottom and oscillate there.

FIG. 1: A schematic illustration of the idea behind the algorithm: a small quantum ball can penetrate through narrow barriers and ﬁnd its way downhill despite the noise in the potential well shape.

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Instead of considering a real quantum-mechanical problem, one can only mimic the quantum behavior to reduce the computational complexities. In [14], suitably deﬁned Markov chains were used for this goal. The algorithm that emerged proved to be useful and statistically robust in γ-ray spectroscopy [15, 16]. Two-dimensional generalizations of the algorithm were also suggested recently [17, 18].

THE INDICATOR

Let Si , i = 1, . . . , n be a price series for some time window. For our purposes, the moving mini-max of this price series, u(S)i , can be considered as a non-linear transformation u(S)i = ui , u1 + u2 + . . . + un (1)

**where u1 = 1 and ui , i > 1 are deﬁned through the recurrent relations ui = Pi−1,i ui−1 , Pi,i−1
**

n

i = 2, 3, . . . , n.

(2)

**Evidently, the moving mini-max series satisﬁes the normalization condition u(S)i = 1.
**

i=1

(3)

The transition probabilities Pij , which just mimic the tunneling probabilities of a small quantum ball through narrow barriers of the price series, are determined as follows Pi,i+1 = with Qi,i+1 =

k=1 m

**Qi,i+1 Qi,i−1 , Pi,i−1 = , Qi,i+1 + Qi,i−1 Qi,i+1 + Qi,i−1 2(Si+k − Si ) , Si+k + Si
**

m

(4)

exp

Qi,i−1 =

k=1

exp

2(Si−k − Si ) . Si−k + Si

(5)

Here m is a width of smoothing window. This parameter mimics the (inverse) mass of the quantum ball and therefore allows to govern its penetrating ability. The moving mini-max u(S)i emphasizes local maximums of the primordial price series Si as illustrated by Fig.2. Its inherent smoothing property is also clearly seen in this ﬁgure. Alternatively, we can construct the moving mini-max d(S)i which will emphasize local minimums. All what is needed is to change Qi,i±1 in the above formulas with Q′i,i±1 deﬁned as follows

m

Q′i,i+1 =

k=1

exp −

2(Si+k − Si ) , Si+k + Si 4

m

Q′i,i−1 =

k=1

exp −

2(Si−k − Si ) . Si−k + Si

(6)

1.2 1 0.8 0.6 0.4 0.2 0 0 0.003 100 200 300 400 500 600

1.2 1 0.8 0.6 0.4 0.2 0 0 0.006 100 200 300 400 500 600

0.002

0.004

0.001

0.002

0 0

100 200 300 400 500 600

0 0

100 200 300 400 500 600

FIG. 2: A price series Si (top) and its mini-max (bottom) for the smoothing window widths m = 3 (left) and m = 10 (right). The solid line corresponds to the up mini-max u(S)i which emphasizes local maximums and the dashed line – to the down mini-max d(S)i which emphasizes local minimums.

That is we change sign to the opposite in all exponents while calculating the transition probabilities.

POSSIBLE APPLICATIONS

Do not trying to foresee the imagination of practitioner traders, we indicate only several possible applications of the new indicator which lay rather on the surface. Resistance and support lines play an important role in technical analysis [11, 12]. To identify lines of resistance and support, traders usually use some moving average indicator. If the price goes through the local maximum and crosses a moving average, we have a 5

resistance line indicating the price at which a majority of traders expect that prices will move lower. A support line happens when the price crosses a moving average after the local minimum. The support line indicates the price at which a majority of traders feel that prices will move higher. The problem is ﬂuctuations of the price which hampers the identiﬁcation of both the local extremums and the corresponding crossing points with the moving average. The new indicator can come to the rescue because it naturally suppresses the noise. We can use u(S) moving mini-max for both the price and its moving average and search for the crossing points of the corresponding moving mini-maxes to identify resistance lines. Analogously, d(S) moving mini-maxes can be used to search for the support lines. It is widely believed that certain chart patterns can signal either a continuation or reversal in a price trend. Maybe the most notorious pattern of this kind is the head-and-shoulders pattern [19, 20]. As the identiﬁcation of this pattern requires to ﬁnd the extrema of the price series, it is evident that the moving mini-max can ﬁnd its application here. As an illustration, Fig.3 shows an alleged head-and-shoulders pattern and the corresponding behavior of the moving mini-max indicators. Note that u(S) and d(S) indicators form a characteristic spindle like pattern at the location of the head-and-shoulders. The same behavior is observed at greater scales in Fig.2.

CONCLUSIONS

We hope that the suggested indicator can ﬁnd its applications in technical analysis. “The classical technical analysis methods of ﬁnancial indices, stocks, futures, . . . are very puzzling” [21]. Nevertheless, many traders ﬁnd them useful and entertaining. It‘s unlikely the new indicator to disentangle the puzzlement, but we hope it can add some new ﬂavor and delight to the occult science of technical analysis.

Acknowledgments

The author thanks V. Yu. Koleda who initiated a practical realization of the suggested indicator and enlightened the author about Forex technical analysis. The work is supported in part by grants Sci.School-905.2006.2 and RFBR 06-02-16192-a.

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0.68 0.66 0.64 0.62 0.6 0.58 0.56 0.54 20 40 60 80 100

0.01

0.005

0

20

40

60

80

100

FIG. 3: A price series Si (top) that exhibit a head-and-shoulders pattern and its mini-max (bottom) for the smoothing window width m = 5. The solid line corresponds to the up mini-max u(S)i and the dashed line – to the down mini-max d(S)i .

[1] E. F. Fama, Eﬃcient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance 25 (1970), 383-417.

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[2] B. G. Malkiel, A Random Walk Down Wall Street, W. W. Norton & Company, 1990, p. 154. [3] M. J. Pring, Technical Analysis Explained, McGraw-Hill, New York, 1991, p.3. [4] B. G. Malkiel, The Eﬃcient Market Hypothesis and Its Critics, The Journal of Economic Perspectives 17 (2003), 5982. [5] B. LeBaron, Technical Trading Rule Proﬁtability and Foreign Exchange Intervention, Journal of International Economics 49 (1999), 125-143. [6] A. C. Szakmary and I. Mathur, Central Bank Intervention and Trading Rule Proﬁts in Foreign Exchange Markets, Journal of International Money and Finance 16 (1997), 513-535. [7] A. Timmermann and C. W. J. Granger, Eﬃcient Market Hypothesis and Forecasting, International Journal of Forecasting 20 (2004), 15-27. [8] C. J. Neely, Technical analysis in the foreign exchange market: a layman’s guide, Federal Reserve Bank of St. Louis Review, 1997, September issue, pp. 23-38. [9] B. Lev and S. R. Thiagarajan, Fundamental Information Analysis, Journal of Accounting Research 31 (Autumn, 1993), 190-215. [10] J. L. Treynor and R. Ferguson, In Defense of Technical Analysis, The Journal of Finance 40 (1985), 757-773. [11] R. D. Edwards and J. Magee, Technical Analysis of Stock Trends, AMACOM, New York, 2001. [12] J. J. Murphy, Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications, New York Institute of Finance, New York, 1999. [13] G. Gamow, Zur Quantentheorie des Atomkernes, Zeitschrift f¨r Physik 51 (1928), 204-212. u [14] Z. K. Silagadze, A New algorithm for automatic photopeak searches, Nuclear Instruments and Methods in Physics Research A 376, (1996) 451-454. [15] T. Wroblewski, X-ray Imaging of Polycrystalline and Amorphous Materials. Advances in X-ray Analysis 40 (1996) http://www.icdd.com/resources/axa/vol40/V40 242.pdf [16] D. L¨bbert and T. Baumbach, Visrock: a program for digital topography and X-ray microdu iﬀraction imaging. Journal of Applied Crystallography 40 (2007), 595-597. [17] Z. K. Silagadze, Finding two-dimensional peaks, Physics of Particles and Nuclei Letters 4 (2007), 73-80. [18] M. Morh´ˇ, Multidimensional peak searching algorithm for low-statistics nuclear spectra, ac Nuclear Instruments and Methods in Physics Research A 581, (2007) 821-830.

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[19] T. N. Bulkowski, The Head and Shoulders Formation, Technical Analysis of Stocks and Commodities 15 (1997), 366-372. [20] G. Savin, P. Weller and J. Zvingelis, The Predictive Power of ”Head-and-Shoulders” Price Patterns in the U.S. Stock Market, Journal of Financial Econometrics 5 (2007), 243-265. [21] M. Ausloos and K. Ivanova, Classical technical analysis of Latin American market indices. Correlations in Latin American currencies (ARS, CLP, MXP) exchange rates with respect to DEM, GBP, JPY and USD, Brazilian Journal of Physics 34 (2004), 504-511.

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