TTRADING TECHNIQUES | Identifying High-Probability Buy Signals It’s rare but possible to generate profits with 97.5% probabilityof success. We can achieve this by adapting some industrial engineering tools, like Six Sigma, 10 the field of technical anatysis. Here, we look at one approach you can use to take advantage of these profitable occasions. ne of the many interesting aspects of technical analysis is the ability to apply ‘mathematical tools and techniques from otherdisciplines to investing. Inthisarticle, wwe propose an innovative avenue based on industrial engineering tools to predict stock market ‘movements and make investmentdecisions. We use the Six Sigma methodology, a technique used mainly in ‘manufacturing environments, to determine if a given process is (or isnt) statistically in control, according to some specific patterns. As the name Six Sigma implies, this methodology identifies events that are outside a 99.97% probability of occurring in a normal distribution. Our objective is to find out if the identification of these patterns in the stock market can be used as buy signals to maximize short-term, one-month returns METHODOLOGY There are 13 possible patterns to identify an out-of control process in the Six Sigma methodology. We individually tested each of those patternsasatechnical indicator on the S&P 500 ETF, the SPY. Six Sigma uses arithmetic averages because in a manufacturing. environment, processes are expected to reproduce the same output. To adapt this technique to the stock market, which ‘was bullish over the years tested January 2010 to June 2016), we had one of our derived indicators use the 20-day simple moving average (SMA) to reproduce the market’s movement. For this exercise, wwe bought the SPY as soon as one of the Six Sigma patterns was observed and sold 22 business days later (one month). Returns were then calculated to determine averages and standard deviationsof returns foreach ofthese buy signals. We then compared the results to abenchmark, whichinthis case was theaverage one-month return of the SPY. We then used the student's t-test, a statistical significance test, to determine which patterns had a statistically higher return than the benchmatk. ‘Those that were higher than the benchmark’s were then tested against nine other exchange-traded funds (ETFs) to determine the universality of these buy signals. The ETFs used were !WM,QQQ,GLD,FXE, XIU,DIA,XLE,EEM, and TLT. Usingastudent’st-test ‘once more, we calculated the percentage probability to demonstrate that our selected signals would deliver higher returns than the expected average. Resuirs Our benchmark, the average one-month SPY, had a 0.93%ereturn, All 13 Six Sigma patterns were computed independently and we concluded that two of the pat- terns we tested generated a much higher return than the benchmark (see the table in Figure 1): erry) oe cE retu | Benchmar: sverage ono-north 1592, 093 [Sconsocuive CLOSE alos blow 20-dayavg. | 22 298 [Sconeecuive decreases of CLOSE values 7 337 FIGURE 1: OE-MONTH RETURNS VS. THEBENCHMARK. Flere yousoethe average ‘one-month reso wo tested pats agaist the SPY. = by Francois Picard, MS, & Edmond Miresco, PhD December 208 * Technic! Anis of STOCKS f COMMODITIES + 9loveseat 4 Sep 14 ee tn seal 20% eat fT il el Sat Lg ha a \ 1 ws tng datas I ‘asco reac FIOURE 2: ONE-MONTH RETURNS USING “BUY SIX CONSECUTIVE DECREASES OF CLOSE VALUES” ON THE SPY. Horo you seo the diferenttuy andsellegrale based on his speci patio. Although buy signals from this model are somewhat rare, they are an excellent way to increase profits due to th high success probability. 1. Nine consecutive close values below the 20-day SMA, and; 2. Six consecutive decreases of elose values. Figure2showsanexample of the buy signals ofsix consecutive decreases of close values on the SPY. A similar exercise as with the SPY was done with the nine other ETFs, This time, the probability of outperforming the ‘market was calculated for both signals for each ETF (see the tables in Figures 3 & 4), Out uf the 10 popula: ETDs, vat buy siguals gave siguilt ‘cantly higher returns (> 95% probability) than the average for four ETFs: QQQ. DIA, EEM, and SPY. If we consider & 75% probability of outperforming the market, then our buy. signals have higher returns in seven to eight out of 10 ETFS, respectively. Figure 5 is another example of how we trade our buy signal of nine consecutive close values below the 20-day SMA against QQQ. ‘THERE'S A HIGH PROBABILITY Using technical indicators that are based on Six Sigma tools and techniques—here, we used six consecutive decreases of lose values and nine consecutive close values below the 20- Fe grees] Mmm | cenmi SESE oT soba scree ier rest ed eee wm | 086 188 : wat | 038 28 aoa | 130 aus wae ‘oo | oar cu | vas om Te co | as oz : re [a “238 = me [asi ost = vay_|o5t 1 oe xu_|__ ost 08 : oa] 0 2st ose oa | om 2 wae | 038 3 x me | 038 120 1 cor | ave ot Ea eo | an 208 5 nr | om 1 om nr | os 28 oe wr [oss 298 ose ser [am a7 ose "Sa iors betta an ewe aed “Ns asa io ttre te cir a abated FIGURE 5: ONE-MONTH RETURNS OF NIE CONSECUTIVE CLOSES BELOW 20- ‘DAY SMA WITH POPULAR ETFS. 10 + Decor 2018 + Technical Anais of STOCKS & COMMODITIES FIGURE 4: ONE-MONTH RETURNS OF SIX CONSECUTIVE DECREASES OF CLOSE \VALUES WITH POPULAR ETFS.an 14 uw Ag 14 stab tt ttt ct 0.00 85.00 ot 4 Nov 14 FIGURE 6: ONE-MONTH RETURNS USING NIME CONSECUTIVE CLOSES BELOW 20-DAY SMA ON QQQ. Hor's lock at the buy and eel erate wading roe ‘conseoitne close values below the 20-day SMA onthe GO. day SMA—allowed us to find buy entry points to get better- than-average returns than the market would have given usin a ‘one-month period, One important point to mentions that these Indicators mut uily wosked ou assets sinh as the SPY, DIA, and s0 on, but also on different asset classes such as GLD or FXE. Although boy signals in this model are somewhat rare, they are an excellent way to increase profits due to their high suceess probability. With a probability of success of 97.5% for the SPY and 90% for most of the others, these signals shouldn't be ignored. Franpots Picard is an engineer and holds both a master’s degree in management from McGill University and amastr's idagree in nancial engineering from PEcole de Technologie Supérieure. He is currenily working asa project manager at GPH, Inc in Montreal He can be reached ar frraarntkSS@ Edmond Miresco is an engineer and holds both a master’s degree in engineering and a doctorate in computing manage- ‘ment from University of Paris- Dauphine. He isa fll professor efproject meanugententurnd financial engineering ut ’Evute de Technologie Supérieure, the engineering school of the Univer- sity of Quebec. He heads the Master Level Short Program of Financial Engineering at the same university and has many years of experience in trading. He can be reached at Edmond. Miresco@etsmil.ca FURTHER READING George, ML... Rowlands, M. Price, & J.Maxey [2008]. The Lean Six Sigma Pocket Toolbook, MeGraw Hill Murphy John J [1999] Technical Analysis Of The Financial Markets: A Comprehensive Guide To Trading Methods And Applications, New York Institute of Finance qh) [von us on Faeabcok at wr ebook om/STOCKSensCOMMOOTIES rt sn Titer sToCKSanaCOHN 12+ Decor 2018 + Technical Ans of STOCKS & COMMODITIES NCU ee eel tes THe AES Traders.com