TA5 Behavioural Indicators

Technical Analysis 5:
Behavioural Indicators
Professor Roy Batchelor
Cass Business School, London
ESCP-EAP, Paris
CESifo, Munich
Roy Batchelor 2012 Behavioural Indicators 2
Session Weekday Weekend Topic

1

Tuesday
8/5/2012
12:00-15:00
LG001

Saturday
2/6/2012
15:00-18:00
G001

What technical analysts do
- Methodology of Technical Analysis
- Evaluating directional forecasts

2

Monday
14/5/2012
09:00-12:00
LG001
Sunday
3/6/2012
12:00-15:00
G001
Statistical Indicators
- Moving Averages and Oscillators
- Evaluating trading rules

3

Tuesday
22/5/2012
12:00-15:00
LG001
Sunday
3/6/2012
15:00-18:00
G001
Pattern Recognition
- Support, Resistance, Reversal and Volume
Indicators
- Bootstrap evaluation of trading rules
Saturday
16/6/2012
11:00-14:00
1001
3 x 1 hour Metastock Classes
(attend in alphabetical order, 11=A-H,12=I-
R, 13=S-Z)

Wednesday
23/5/2012
15:00-18:00
1001
3 x 1 hour Metastock Classes
(attend in alphabetical order, 15=A-H,
16=I-R, 17=S-Z)

4

Tuesday
29/5/2012
12:00-15:00
LG001
Saturday
16/6/2012
15:00-18:00
Wave Theory
- Dow, Elliott, Gann and Fibonacci
- Gamblers Ruin and the Kelly Rule.

5

Tuesday
12/6/2012
12:00-15:00
LG001
Sunday
17/6/2012
09:00-12:00
Behavioural Indicators
- Biases in Investment Decision-making
- Smart Money Indicators

6

Tuesday
19/6/2012
12:00-15:00
LG001
Sunday
17/6/2012
13:00-16:00
Chaos Theory, Neural Networks and Expert
Systems
- Heterogeneous agent models and chaos
- Combining technical indicators

Plan of session
Class test
Behavioural Biases and Heuristics
Implication for Technical Analysis
Trader position indicators
Class test
Exam conditions
No open books
No talking
No copying
No writing (until asked)
Use the clickers ..... Which we will now test
Plan of session
Class test
Rational economic man
Stable Utility
Function:
consistent attitudes
to risk and return
Rational
Expectations
Hypothesis:
uses information and
makes decisions in a
statistically optimal
way
Misconceptions about the REH
Fallacy 1. Academics think its literally true
Its just a benchmark (like the frictionless surface)
Fallacy 2. It means everything follows a random walk
Markets are made efficient by trading on forecasts, and this
wont happen unless traders are rewarded
Exchange rate fundamentals need not follow a random walk
(though fixed horizon forex futures prices will)
Return depends on risk and risk is to some extent predictable
Bubbles are rational and so strong price trends can occur
Some problems in the rational model
Predictions of EM Model:
No rewards to forecasting
Single agreed fundamentals-
based forecasting model
No speculative trades, since
all beliefs are identical.
Prices tracking
fundamentals.
Observations:
Market can only be made efficient by efforts
of forecasters (Grossman and Stiglitz)
Many different models and theories,
including TA and fundamentalists
A lot of trade, with trading volume
uncorrelated with fundamentals
Excess volatility (Shiller), and FX rates,
stock prices persistently away from
fundamentals
Behavioural finance man
Unstable
Preferences:
inconsistent attitudes
to risk and return
Bounded Rationality:
biases in processing
information
heuristics (rules of
thumb) used to make
decisions
Risk and utility mental experiment
Suppose investors can put 100m in either
a safe 1-year bond which definitely pays 5%
A stock market investment which might pay +20% or -20%
Risk-averse investor A will buy the bond
Risk-loving investor B might buy the stock market investment
How will they feel at the end of the year?
Investor A
Rational model:
get happiness =utility of 105m =U(105), a fixed number
no incentive to change behaviour next year
Behavioural model:
happiness depends on what happens in the stock market
if investment fell, U(105) is very high (Schadenfreude)
if risky investment rose, U(105) is not so high (Regret)
investor experiencing regret may take more risk next year
Investor B
Rational model: get happiness =U(80) or U(120)
fall in utility from -20% is bigger than rise from +20%
Behavioural model(s):
Prospect Theory:
if market falls, takes more risk to recoup losses
if market rises, takes less risk to preserve gains
House Money theory:
if market rises, investor takes more risk since is now
playing with the house money
Prospect Theory
Evidence favours Prospect Theory over House Money theory
Chicago Day Traders take more risks p.m. if they lost a.m.
Hedge Funds lock in above-average first-half-year returns
Prospect theory explains some trader/ investor behaviour: e.g the
disposition effect -
tendency to hang on to losers
(due to increased risk-taking after losses)
tendency to sell winners too soon
(due to decreased risk-taking after gains)
Behavioural finance man
Unstable
Preferences:
inconsistent attitudes
to risk and return
Bounded
Rationality:
biases in processing
information
heuristics (rules of
thumb) used to make
decisions
Behavioural biases
Investors are subject to biases in collection and processing of
information:
Poor intuitive statistical reasoning
Anchoring, availability and framing biases
Overconfidence and Illusion of control
Deal with uncertainty by employing heuristics (rules of thumb)
Poor intuitive statistical reasoning
Representativeness heuristic
Cannot replicate Bayes Theorem from verbal information
Anecdotes v. Numbers
Narrative: Tom W. is of high intelligence although lacking in
true creativity. He has a need for order and clarity, in which
every detail finds its appropriate place. His writing is rather dull
and mechanical, enlivened by somewhat corny puns. He seems
to feel little sympathy for other people. Self-centred, he
nonetheless has a deep moral sense.
Group A. This description has been drawn randomly from a
folder containing CVs of 30 Engineers and 70 Lawyers.
Group B. This description has been drawn randomly from a
folder containing CVs of 70 Engineers and 30 Lawyers.
What is the probability that Tom W. is an engineer?
Are you persuaded?
FX markets have two states random walk (95% of the time)
and trending (5% of the time)
A trading system claims the following success rates:
If the market is trending the system will (correctly) identify
this 99% of the time
If the market is not trending the system will (incorrectly) say
that it is trending with only 5% probability
Suppose the system says the market is trending. How likely is
this to be true?
Law of Truly Large Numbers
In 1986 Evelyn Adams became the first person ever to win more
than one million dollars twice in any state lottery.
After consultation with a professor of statistics at Rutgers
University, lottery officials concluded that the odds of one
person winning the top lottery prize twice in a lifetime were 1 in
about 17.3 trillion..." ("Odds-Defying J ersey Woman Hits
Lottery J ackpot 2d Time," The New York Times, Feb. 14, 1986).
What do you think?
Anchoring and Availability
Anchoring heuristic: people tend to grab any available number
when making a forecast in an uncertain environment
Leads to:
Conservatism in forecast revisions
Stock-picking rather than diversification
Support, Resistance and Anchoring
Support and resistance
often found at obvious
anchors such as:
Recent highs and lows
Big round numbers
Round numbers may also
reflect option exercise and
retail order flow.
Conservatism in earnings forecast revisions
How to lie with statistics .
but actually
Overconfidence: The F-test
Academic studies show that about 80%
of you think you are above average with
respect to being witty, driving a car,
doing your job, living for a long time.
Overconfidence is highest when there is:
a lot of (not necessarily helpful)
information
little relevant feedback (do
subscriptions and bonuses count?)
Leads to
Failure to learn from errors
Illusion of Control
Confidence boosting behaviours
Performance attribution:
If Ive made money, it shows I have skill
If Ive lost money, well thats just bad luck
Hindsight bias. I knew it all along
Self-rated probabilities of an event (e.g. sub-prime collapse)
much higher after the event has occurred than before
People often deny earlier opinions, rewrite history
(Greenspan wrong not to burst asset price bubbles earlier)
Illusion of Control: Overexplaining
Bloomberg Commentary on
Monday 15 Dec 2003:
13.01 US Treasuries Rise. Hussein
capture may not curb terrorism.
13.31 US Treasuries fall. Hussein
capture boosts allure of risky
assets.
Plan of session
Class test
Implications for Technical Analysis
Irrationality puts patterns in prices
Irrationality also makes you see patterns that arent there
Price patterns after Good News
Path if news is soft
(statements, forecasts,
plans, ..)
Over-reaction due
to overconfidence in
new situations
Path if news is hard:
(economic data)
Price patterns after Bad News
Path if bad news is hard
initial underreaction due to
reluctance to realise losses
Path if news is soft
The traders and the mouse
Fenton OCreevy, M., N. Nicholson, E. Soane and P.
Willman, Journal of Occupational and
Organisational Psychology 2003
Traders told to control a dot on the screen using
keystrokes, so as to keep the dot in top right segment.
Most reported success as experiment progressed, even
though movements in the dot were random.
Illusion of control:
inversely related to profit contribution and
remuneration, analytical skills
directly related to people skills
Directly related to religiosity, superstition, belief
in ESP, (Blackmore and Troscianko, 1985, British
J ournal of Psychology)
Assessment of Technical Analysis
Characteristics of a good forecasting system:
Formal models better than unaided judgment
Models should give most weight to recent data
Accuracy improved by combining models (and judgement)
TA has many characteristics of a good forecasting method
Adaptability to structural change
Emphasis on confirmation
But subject to limitations highlighted by behavioural finance:
Emphasis on informal and judgmental methods means
analysts very vulnerable to bias
How not to be irrational
Keys to success are:
rigorous scientific testing of methods to control data mining
(beyond backtesting: e.g. bootstrap methods)
continuous objective feedback, with rewards for success and
failure linked to the forecast
Some forecasters are known to be unbiased: e.g.
Weather forecasters
Betting Odds setters/ Information Markets
Market professionals
Plan of session
Class test
Smart Money Indicators
In a market with heterogeneous agents, rational expectations
formation is almost impossible, since it requires knowing other
agents beliefs
Some TA indicators try to infer beliefs of other well-informed
traders: e.g.
NYSE Members Short positions
Commitment of Traders Reports
Call-Put Ratio and VIX Index
Investment Intelligence
NYSE Members short positions
Member Trades: If specialists, floor traders and other members
of the New York Stock Exchange are shorting heavily the
market is usually ripe for a correction. On the other hand, if they
are doing relatively little shorting it is most likely that the market
has hit bottom.
The Members / Public Short Ratio is calculated by dividing the
volume of the weekly short sales made by stock exchange
specialists (members) and those made by the public
(nonmembers), by the volume of total short sales.
NYSE member trades
CFTC Commitments of Traders Report
The Commodity Futures Trading Commission provides
information every Friday about positions taken during the week
by Commercial Hedgers and Large Speculators. (Positions of
Small Traders can then be calculated)
Commercial Hedgers hold a significant informational edge over
other traders as far as fundamental supply-and-demand statistics
are concerned. Follow commercial hedgers to pick up on long
term trends.
Small traders are liable to be less well informed. So high ratio of
long to short positions taken by small traders would be a sell
signal.
Commitment of Traders: $/Euro
Small traders buying,
informed traders selling
Sell signals in Jan 09 and Apr 09
Selling profitable for
informed traders
Large Speculators OI, Oil and Gold
Indicators from options markets
Pu-Call Volume Ratio is calculated by dividing the weekly
volume of Put options by the weekly volume of Callt options.
Big Put volume appears at market bottoms and big Call
volume at tops.
VIX (CBOE Volatility Index) computes volatility of four OEX
contracts in two nearby months and is published daily by the
CBOE. Options selected for this index are one call and one put
just out of the money, and one call and one put just in the
money, for each of the two front months of the OEX (S&P 100).
Extremely high readings of VIX indicate bottoms and low
readings tops.
Put-Call Ratio
Indicator used as oscillator
Buy when ratio has
been high but is falling
(high number of puts
means excessive
pessimism)
Sell when ratio has
been low but is rising
(high number of calls
means excessive
confidence)
VIX: Leading or Lagging?
Investors Intelligence index
Based on a survey of
140 investment
newsletters by
Investors
Intelligence
Trade on
turning points in
ratio
excessive bull or
bear counts (e.g.
sell if ratio >2, buy
if >0.6)
In every market there is a fool
To make money, seek to trade against the fool
If you dont know who the fool is
then its probably you

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