Evidence-Based

Technical
Analysis
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Evidence-Based
Technical
Analysis
Applying the Scientific
Method and
Statistical Inference
to Trading Signals

DAVID R. ARONSON

John Wiley & Sons, Inc.

Copyright © 2007 by David R. Aronson. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
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Library of Congress Cataloging-in-Publication Data:
Aronson, David R., 1945–
Evidence-based technical analysis : applying the scientific method and
statistical inference to trading signals / David R. Aronson.
p. cm.—(Wiley trading series)
Includes bibliographical references and index.
ISBN-13: 978-0-470-00874-4 (cloth)
ISBN-10: 0-470-00874-1 (cloth)
1. Investment analysis. I. Title. II. Series.
HG4529.A77 2007
332.63'2042—dc22
2006014664
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
To Jack and Belma
 Contents

Acknowledgments ix

About the Author xi

Introduction 1

PART I Methodological, Psychological,

Philosophical, and Statistical
Foundations

CHAPTER 1 Objective Rules and Their Evaluation 15

CHAPTER 2 The Illusory Validity of Subjective

Technical Analysis 33

CHAPTER 3 The Scientific Method and Technical

Analysis 103

CHAPTER 4 Statistical Analysis 165

CHAPTER 5 Hypothesis Tests and Confidence Intervals 217

CHAPTER 6 Data-Mining Bias: The Fool’s Gold

of Objective TA 255

CHAPTER 7 Theories of Nonrandom Price Motion 331

PART II Case Study: Signal Rules

for the S&P 500 Index

CHAPTER 8 Case Study of Rule Data Mining

for the S&P 500 389

CHAPTER 9 Case Study Results and the Future of TA 441

vii
viii CONTENTS

APPENDIX Proof That Detrending Is Equivalent to

Benchmarking Based on Position Bias 475

Notes 477

Index 517
 Acknowledgments

T
hough a book is attributed to its author(s), it truly reflects the efforts
of many more people. I wish to acknowledge those individuals
without whom this book would have been impossible or a much
lesser work.
I am most indebted to Dr. Timothy Masters, whom I have had the plea-
sure of knowing for over 10 years. His patient and intelligent guidance
kept me on a solid statistical footing. Tim not only gave me important feed-
back on technical issues but was responsible for coding and running the
ATR rule experiments and the statistical routines used to test the over
6,400 rules examined. Tim also innovated the Monte Carlo permutation
method as an alterative to the patented method of White, called Reality-
Check, for testing the statistical significance of rules discovered by data
mining. Tim has graciously decided to put the method in the public domain
and has allowed it to be published for the first time here.
Also crucial were the programming talents of Stuart Okorofsky and
the database creation by Dr. John Wolberg. I am indebted Dr. Halbert
White, inventor of Reality-Check and for the help of Professor David
Jensen, director of the Knowledge Discovery Lab at the University of
Massachusetts–Amherst.
I also wish to express my appreciation to the following people for re-
viewing and commenting on various chapters. Their feedback was essen-
tial: Charles Neumann, Lance Rembar, Dr. Samuel Aronson, Dennis Katz,
Hayes Martin, George Butler, Dr. John Wolberg, Jay Bono, Dr. Andre Shle-
fier, Dr. John Nofsinger, Doyle Delaney, Ken Byerly, James Kunstler, and
Kenny Rome.
Special thanks to the helpful folks at John Wiley & Sons: Kevin Com-
mins, for seeing the value of a critical appraisal of technical analysis, and
Emilie Herman, for her steady hand in editing the book. Thanks as well to
Michael Lisk and Laura Walsh.

ix
 About the Author

David Aronson is an adjunct professor of finance at Baruch College’s Zick-

lin School of Business in New York, where he teaches a graduate-level
course in technical analysis to MBA and financial-engineering students,
and vice-president of Hood River Research Inc., a firm that develops signal
filters and predictive models. He was formerly a proprietary trader and
technical analyst at Spear, Leeds and Kellogg and president of Raden Re-
search Group Inc., a consulting firm that developed the data-mining soft-
ware PRISM and filters and systems for various trading firms. Prior to that,
he founded AdvoCom Corporation, which managed client funds in portfo-
lios of futures trading advisors using portfolio optimization. He received a
BA in philosophy from Lafayette College in 1967 and served in the Peace
Corps in El Salvador.

xi