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Pieter Verstuyf In collaboration with Lukas Verret Master Business Economics

Promotor: Prof. Dr. P. Sercu


ABSTRACT Hier komt een korte omschrijving van je masterproef waarin je de motivatie voor het onderzoek en de resultaten kort voorstelt in ongeveer 250 woorden. (default/standaard)


Table of contents
Acknowledgements .............................................................................................................................................. 3 Table of contents ................................................................................................................................................... 4 I. II. Introduction ..................................................................................................................................................... 5 (Some) literature and hypotheses ......................................................................................................... 6 Stock Market Index Futures ......................................................................................................................... 6 III. IV. V. VI. The Trading Model ..................................................................................................................................10 Results ........................................................................................................................................................... 27 Discussion...................................................................................................................................................... 37 Conclusion ................................................................................................................................................... 41

Sources .........................................................................................................................................................................42 Appendix A..................................................................................................................................................................45



This thesis looks at the profitability of technical trading rules in stock index futures markets with the use of resampling methods. The focus of this research is an extension on the subject of profitability of technical trading rules in futures markets introduced under our supervisor, Professor Piet Sercu, to several finance students at the Katholieke Universiteit Leuven. For a detailed literature review on the subject relevant to our empirical research, we refer to our joint paper with 7 other master students (Technical Analysis in Futures Markets: A Literature Review, 2011). To introduce our thesis statement, it is important to reiterate that weak-form market efficiency states that past information cannot be used to consistently generate excess returns (Fama, 1970). Technical analysis, which uses past information on securities, should thus be ineffective in generating consistent abnormal profits in an efficient market (Raj & Thurston, 1996). While Park and Irwin (2008) observe that the efficacy of technical analysis on futures markets is still largely unexplored territory compared to other stock markets, we find the specific research field on trading rule profitability in stock market index futures to be even more barren ground and concentrate our research on this type of market (Sutcliffe, 2006). We use Whites Reality Check (or Whites RC) to test a trading rules predictive superiority on profitability over a benchmark model while accounting for a data snooping bias and transaction costs. Results indicate strong significant positive returns in specific smaller markets. On one hand, the information content of these results is heightened by the measurement of additional significant positive returns obtained under a block bootstrap method (or BBM) and a Henriksson-Merton Market Timing model (or HMMT). On the other hand, this finding may be overly optimistic as it assumes we can immediately trade at the settlement price that is also the most recent input into the rule. Nonetheless, it encourages additional research on more extensive databases that also include the next opening price.


(Some) literature and hypotheses

Stock Market Index Futures We use Sutcliffes (2006) book on stock index futures as our main reference manual when relating our research to the specific characteristics of this type of future market. This is essential as, contrary to results on trading rules in stock markets and other futures markets, he posits that the evidence on time related anomalies in index futures contradicts weak-form market efficiency. Sutcliffe starts out with a definition of stock index futures as being in essence, a bet on the value of the underlying index at a specified future date. The first such stock index futures originated in the US in 1982 with some of the stock index futures we researched starting out in 1999. Like all future contracts, stock index futures were designed to be traded continuously and since their inception trading has rapidly grown, with the value of trading often rising to, or even exceeding, the same order of magnitude as the value of transactions in underlying shares. This order of magnitude of trading in futures for which the underlying asset is not traded as such has caused some concerns regarding the responsibility of stock market index futures for the occurrence of financial crises. Indeed, these newer financial instruments are subject to different laws and regulations. Among other things, this has led to, so far, lower taxation costs on profits made in these markets. A number of advantages of trading in stock index futures over shares are known: Firstly, short selling is easy, as many trades in index futures involve someone taking a short position, while shorting of cash shares involves various difficulties related to the cost of borrowing shares. Secondly, transactions costs are lower. Kling (1986) argues: There is no reason for the existence of financial futures if they do not have lower transaction costs. Transaction costs for trading futures comprise of (i) a commission, which is a positive function of price volatility, the bid-ask spread, and a negative function of order size and trading via screens (Bortoli, Frino & Jarnecic; 2004); (ii) market impact; (iii) the opportunity cost of the funds used in paying the initial margin and

accounting for eventual margin calls; (iv) taxes, if any; and, (v) as Greer & Borsen (1989) suggest, an allowance for execution risk. For index futures denominated in a foreign currency there is also the currency bid-ask spread. Thirdly, the market for index futures is much more liquid than the market for shares in individual companies. Fourthly, if index futures are directly purchased, the position is taken by a single transaction1. With contracts for difference and spread betting, and the emergence of exchange traded funds further enhancing transaction ease, along with eliminating the non-synchronicity problem (ap Gwilym & Sutcliffe, 1999, 2001). There is also some evidence that the market impact of a trade is unaffected by a drop in volume over time periods (Park & Sarkar, 1994). Lastly, most index futures markets use screen based trading, which permits long trading hours and makes the market place larger. Hypotheses According to the academically strongly supported Efficient Market Hypothesis, significant profits cannot be made on stock markets by using only tools that try to predict future outcomes using an information set derived from past price events, a category in which trend-based Technical Analysis fits (Fama, 1970; Jensen, 1978; Harder, 2010). Any proof to the contrary, accounting for transaction cost and level of risk, would be an indication of weak-form market inefficiency. As such, our research question boils down to the following: Is an investor using Technical Analysis capable of generating significant abnormal returns in stock index future markets? In formulating hypotheses that indicate an answer to this question, we start out with the logical null hypothesis that has been used in research preceding our thesis (Geypen, 2008; Park & Irwin, 2007):

Comment [CK1]: I would include cost o capital, which is related to risk premiu but is the cost of rising the sufficient equity capital required to support the exposure

It must be noted that on non-US exchanges, one can buy entire baskets of shares like the BEL20 with a simple mouse click. This still implies that one possesses an adequate model to simulate the stock index and hardware to decrease execution time however;

H1: Technical analysis does not produce significant abnormal returns in stock market index futures The outcome of this hypothesis can take on many forms and include many parameters. We formulate some sub-hypotheses that address major gaps in earlier research in the field, as mentioned in our joint literature study. More precisely we dig deeper into the more relevant problems of data snooping and the effect of transaction costs (Park & Irwin, 2010): H1a: Technical analysis does not produce significant abnormal returns in stock market index futures when accounting for data snooping. H1b: Technical analysis does not produce significant abnormal returns in stock market index futures when accounting for transaction costs We also want to research general trends that may affect profitability, as market efficiency holds if a satisfactory economic explanation for any profit is found. A first relevant hypothesis refers to a number of studies that find better results in smaller and less developed markets, as well as a higher success rate for technical analysis in those markets (Bessimbinder & Chan, 1995; Oberlechner, 2001; Gaunt & Gray, 2003) H2: Results will be more significant in smaller, less developed markets. The second trend concentrates on the late-2000s financial crisis, a true bear market. We consider futures markets as highly liquid, where shorting or potentially profiting from a decline in price faces little difficulty. With technical analysis generating buy and sell (or long and short) signals from past price information, any significant abnormal returns should be robust in both bull and bear markets, which we can add as a condition to our first hypothesis. Both parts of the market cycle differ, however, in such matters as volatility and risk. So we expect the investment and risk profile of a sample period that includes the financial crisis to differ from the one before it, while returns on any

successful trading rules should remain consistent across time periods. We define three related testable hypotheses in accordance with these considerations: H3a: Significant positive returns in stock index futures markets are made both in a bull market as in a bear market. H3b: There is a persistence of returns from trading rules across time periods. H3c: Any significant return during a bear market will have a lower Sharpe ratio than in a similar bull market with equally significant returns. Lastly, several authors note the discrepancy between academic research and actual trader practices. Sutcliffe (2006) comments that traders will have at their disposal a battery of indicators, which they use in conjunction. We therefore also test whether a combination of trading rules outperforms singular trading rules.


The Trading Model

We concentrate on a comparison of stock market index futures. The representing data was retrieved from Thompson Reuters Datastream on the basis of a number of criteria. Firstly, we required a certain number of data-points, with all indices spanning a period from 1/1/2001 until 31/12/2010. Secondly, we attempted to include as many smaller, less developed markets as were available to us in Datastream, given the better results in earlier research, while still including some developed control markets to further confirm or deny the hypothesis that smaller, less developed markets are less efficient. Finally, we chose blue-chip indices that serve as their respective national benchmark, rather than more specialized indices. This might provide for insights that could theoretically be extended to general returns per country in futures markets. Hence we came to the American S&P 500, arguably the most developed and efficiently traded future index market; Brazils ndice Bovespa; the Japanese NIKKEI 225, Hong Kongs Hang Seng and South Koreas KOSPI Index in East-Asia; and in Europe, Belgiums BEL 20, the Spanish IBEX 35, the Hungarian BUX and the Portuguese PSI-20 Index. We researched these time series in its totality from 1/1/2001 to 31/12/2010, as well as comparing results in two subperiods. The first subperiod runs from 1/1/2001 to 30/12/2005, the second from 2/1/2006 to 31/12/2010, with the latter including the financial crisis and rebound. The data consists of daily closing prices of each index future market. Datastream creates a continued time series by rolling over through closing out of a contract on a certain date in their delivery month and taking a position in a new contract with a future settlement date right after. The price of a future stock will converge with the spot price as the settlement date nears and time value diminishes, resulting in price shocks right before the settlement date. By rolling over in the delivery month before the actual delivery date these are largely negated, as the new futures stock will

contain the higher time value of a future settlement date before convergence. We do make the assumption that the price of a futures stock with a more future delivery date is almost identical to the price of the same futures stock with the nearby delivery date on the rolling over date. Should this assumption be wrong, rollover costs might be greater than expected as spurious price jumps arise that do not correspond to a genuine return and may mess up indicator signals. When comparing some prices however, we find that our assumption largely holds.

Performance criteria and assumptions A trading model usually consists of input data, trading systems, performance measures, optimization methods and other relevant assumptions. The trading model used here is comparable to the one of Lukac et al. (1988) and Park and Irwin (2010) The input data consists of daily futures prices. Since multiple contracts of the same index exist, we chose to pick the most nearby contract, as this is often the most traded one. Additionally, as a contract reaches its maturity date, most traders close out their position, which results in a lower liquidity and higher volatility. Therefore the contract is rolled over as soon as it reaches its last month. The performance criteria used here are the mean gross and net return, and the Sharpe ratio. Calculating returns in the zero-sum futures markets is not straightforward, as there is no traditional initial investment to calculate2 . Blacks (1976) widely accepted logic was that the sum

invested is thus zero, although this limits the extension of the traditional concept and tests of market efficiency. Out of necessity, empirical studies have turned towards the percentage price change or the logarithm of percentage price changes to calculate returns. The logarithm of prices has the

The initial margin payment does not flow from buyer to seller but rather both position takers have to deposit a margin payment at a clearing house.

advantage of being scale independent and we therefore follow earlier research by using the continuously compounded log return. This choice matters because there are some indications that conclusions in empirical studies differ when different measures are used (Yau, Savanayana & Schneeweis, 1990, Szakmary & Mathur, 1997; Sullivan et al., 1999; Park and Irwin, 2010). This daily gross return from trading rule k at time t is , ( ) ( )-,

where Sk,t is the signal function of trading rule k and equals 1, 0 or 1. The net return is calculated following Park and Irwin (2010) ( ) ( ),

where n is the number of round-turn trades for a contract, Nin is the number of days in which you take a position in the market, dt+1 is indicator which equals 1 when you are in the market and c is the value for round-turn proportional transaction costs. We use 0.25% and 0.50% for the transaction costs. In addition to the returns we also calculate Sharpe ratios. This popular measure computes the excess return per unit of total risk, for trading rule k this ratio equals:

where is the annualized mean net return and denotes the standard deviation. Note that the risk free rate is omitted in the formula above because there is no initial investment needed3. In this thesis we not only test standard rules; rather, we also look for the best variant for instance by varying the number of days in a moving average. The reason why we are letting these parameters vary is twofold. Trading rules are often implemented with different time horizons; the

Comment [CK2]: Again, I am missing th cost of equity capital in this discussion. may be OK to omit it for the period you are looking at, but it will, as regulation tightens following the financial crisis, i will become a more important parameter in the future.

Only a margin deposit is necessary, this can be in the form of cash, which can earn interest, but often T-Bills are also accepted. Therefore the margin does not really have a cost.

typical trade-off is mainly between slowly versus fast-reacting rules. While fast-reacting rules obviously respond faster to market movements, they also cause more false breakouts because they react too soon which also causes higher transaction costs. More slowly reacting rules, on the other hand, would generally indicate more reliable signals because they indicate a reversal in a long-term trend, but with a delay. The standard parameters of a trading rule can also be the result of a subtler survivorship bias. Suppose that over time investors have tested all the feasible parameterizations of a particular rule. As time advances more and more parameters are discovered to be unprofitable in that data set and are ultimately forgotten. The parameters of the concerning rules that keep generating profits in that data set will get more and more attention by the investment community. After a sufficient period of time, only a few will survive and their track record will be cited as evidence for their superior performance. However this does not mean that they genuinely possess real predicting power: if the universe of parameters is large enough, even pure luck can deliver such a rule. The effects of such data snooping, operating over time and across the entire investment community and researchers, can only be detected if one considers the full universe of trading rules (Sullivan et al., 1999). Alternatively, when the necessary dates are available an out-of-sample period can also be used to relieve this bias. Considering that in practice there is a need to find the most profitable trading rule for tomorrow, these necessary dates are hard to come by.

Trading Rules Simple Moving Average Crossover (SMAC) a) The simple moving average crossover is an indicator that utilizes a short term moving average (MAst) and a long term moving average (MAlt). The moving averages are calculated using equal weights.


( ) ( )

a= 5, 15, 50 b= 15, 50, 200

These combinations give us 6 different rules. b) A buy signal is generated when MAst(t) is above MAlt(t), which would indicate a rising trend. A negative trend would be indicated when MAst(t) drops below MAlt(t) and this would thus generate a sell signal. i. ii. Long (buy at Pt) when MAst(t) > MAlt(t) Short (sell at Pt) when MAst (t) < MAlt(t)

Weighted Moving Average Crossover (WMAC) a) The weighted moving average crossover is similar to the SMAC. The only difference is that there is given more weight to recent observations and less weight to ones who are more distant. The weights given to each observations decline linearly. a<b ( ) ( )
( ( ( ( ) ) ) )

a= 5, 15, 50 b= 15, 50, 200

These combinations give us 6 different rules. b) Buy and sell signals are generated in an identical way as the SMAC: i. ii. Long (buy at Pt) when WMAst(t) > WMAlt(t) Short (sell at Pt) when WMAs(t) t < WMAlt(t)

Exponential Moving Average Crossover (EMAC) a) The exponential moving average crossover is a specification of the WMAC: again more weight is given to the most recent observations but this time the weight decline exponentially with each observation. ( ) ( ) ( ) {


( )

) {

These combinations give us 6 different rules. b) Buy and sell signals are generated in an identical way as the MAC and the WMAC: i. ii. Long (buy at Pt) when EMAst(t) > EMAlt(t) Short (sell at Pt) when EMAs(t) t < EMAlt(t)

Momentum (MOM) a) Momentum is a ratio which measures the relative price measures over a fixed time period. A signal line is constructed by an MA of the MOM ratio. ( ) ( )
( )

a = 5, 15, 50, 200 b=9

This gives us 4 different rules. b) A buy signal is generated when MOM is above the signal line, a sell signal when its below. i. Long (buy at Pt) when MOM(t) > s MOM (t)


Short (sell at Pt) when MOM (t) < sMOM(t)

Moving Average Convergence Divergence (MACD) a) The MACD is the difference between a short term and a long term EMA. A signal line is constructed by using an EMA of 9 days of the MACD itself. () ( ) ( ) {

( )

This gives us 1 rule. b) Like with MOM, a buy signal is generated when the MACD is above the signal line, a sell signal when its below. i. ii. Long (buy at Pt) when MACD(t) > sMACD(t) Short (sell at Pt) when MACD(t) < sMACD(t)

Percentage Price Oscillator (PPO) a) The Percentage Price Oscillator (PPO) indicates the relative change between a short and a long term EMA . This gives us 6 different rules. ( )
( ) ( ) ( )

b) A buy signal is given when the PPO is positive, thus when the short term EMA is larger than the long term, a sell signal when its negative. i. ii. Long (buy at Pt) when PPO(t) > 0 Short (sell at Pt) when PPO(t)< 0

Price Channel (PC) a) A buy signal is simply generated when the current price is higher than the maximum of a fixed number of days. A sell signal arises when the price drops below the minimum. i. ii. Long (buy at Pt) when Pt > max(Pt-1, Pt-2,, Pt-a) Short (sell at Pt) when Pt < min(Pt-1, Pt-2,, Pt-a) a = 5, 15, 50, 200 This gives 4 rules. All rules combined (COMB) a) There has been some critique that professional traders do not take decisions based on one simple trading rule (Park and Irwin, 2010). We try to overcome this by composing an additional rule that encompasses signals drawn from the simple trading rules we use. The combined signals would ideally complement each other, the added value resulting in superior performance. Recent research has produced some promising results towards such a performance on the S&P 500 (Lento, 2008). The main problem that arises is the choice of complementary trading rules: the combination of the trading rules with the best performance is a logical choice, but this information can only be retrieved from the performances during period 1 and therefore only applied for subperiod 2. So on all markets in the second period we apply a single rule that combines the best performing rule of each market in the first period. As we have no clue which rules have superior performances

at the beginning of subperiod 1 or the total period, we limit ourselves to combining the signals of all our simple trading rules to avoid defining any ex-ante strategy that includes arbitrarily picked rules. The rule itself simply looks at the number of buy and sell signals generated by the rules of which it is composed. If there are more buy than sell signals, it generates a buy signal. If there are more sell signals, it gives a sell signal. I. II. Long (buy at Pt) when Short (sell at Pt) when

Statistical tests Since we are letting the parameters of our trading rules vary to find the optimal rule, there exists a real chance of data snooping: we may find the rule that best captures strange quirks in this data set. To offset this, we use different methods to test the significance of our results that account for datasnooping: a block bootstrap method and Whites Reality Check (2000), the latter which specifically accounts for data snooping. An additional robustness check is performed by using the markettiming model of Henriksson and Merton (1981). Block bootstrap method Bootstrapping as described by Efron (1979) is a familiar technique in the literature on technical analysis; see already Brock et al. (1992) and Bessembinder and Chan (1998). The basic concept behind bootstrapping is to draw random samples from the original data or to sample from the sample (Sercu, 2009). The particular type of bootstrap used here is a block bootstrap; meaning that the random samples are drawn in blocks of a certain size. The advantages of the block bootstrap are that it can be used with almost any sort of dynamic model and that it can handle heteroskedasticity as well as serial correlation (Mackinnon, 2006).

The questions are now which block size we are going to use and how many resampled time series we need. Concerning the block size we choose to only use two large blocks. Although our tests did not indicate any notable effects when varying block size, we state two reasons why this is a theoretically sound choice. The first and most important one is that the autocorrelations from the original series remain preserved. The second one is that the exact number of buy and sell signals remains the same. As a consequence, when including transaction costs the amount will be exactly the same as in the original series. Regarding the number of bootstraps, we look at Brock et al. (1992) and Kho (1996) who illustrate that their results are not sensitive to expanding the number of resampled series beyond 500. However if one wants a more formal way to determine the minimum number, it can be provided by the three-step method of Andrews and Buchinsky (2000). The algorithm used for resampling the buy and sell signals of rule k for of each bootstrap b, where b=1,,B is : Draw a random number between 1 and N Observation 1: draw Sb() from the original sample of buy and sell signals. Observation n: draw Sb (+ n -1) When (+ n -1) reaches N, let us say at observation (+ m), the next observation (+m+1)

equals Sb (1) Observation + m +2: Sb (2) Until n=N

Graphical representation: n 1 Signal (S) Buy

n +1 +2 N =+m Sell Sell Sell N=+m Buy 1 +1 +2

Signal (Sb) Sell Sell Sell Buy Buy

Zeker dat alles erin zit dan? The rest of this method is similar to the Monte Carlo simulation we used. For the next step we calculate the mean annualized return for the original series and for each bootstrapped series: For each bootstrap b, the mean return is calculated:

so we can calculate significance levels by the formula:

where 1{} is an indicator function that equals one if the expression between brackets is true and zero otherwise. We reject the null hypothesis at the % significance level if pmc (/100).

Whites Reality Check: By building on previous work of Diebold & Mariano (1995) and West (1996), White (2000) developed a method to test whether a given model has predictive superiority over a benchmark model taking into consideration that there is a possible chance of data snooping. While the two

previous methods are perfectly valid methods, they miss this specific feature that is of great importance for this paper. The key idea is to assess the distribution of a suitable performance measure taking into account the full universe of trading rules that lead to the best performing trading rule (Sullivan, Timmerman and White; 1999). P-values are calculated by comparing the performance of this best rule to approximations of the asymptotic distribution of the performance statistic. The difference from previous methods is that this allows us to directly resample observations of a performance statistic and not just merely return series like in previous methods. The performance measure utilized to evaluate the performance of each of k trading rules, where k=1,, m and m= 49, is: Yk,t+1 = rk,t+1 r0,t+1, rk,t+1 and r0,t+1 are daily net returns, rk,t+1 for trading rule k and r0,t+1 for the benchmark. Following the literature (Geypen, 2008; Park and Irwin, 2010), we assume zero profit as the benchmark. Although buy-and-hold might be a more appropriate estimator of the risk premium, so could the sharpe ratio and a number of other measures. Failing to find a conclusive estimator of the risk premium, we at least achieve greater comparability with earlier research. Consequently by preserving the expectation of r0,t+1 equaling zero, the performance measure only consists of rk,t+1. The null hypothesis is then defined in the following way: provided that for each trading rule k, ( ) is well defined: . This condition states that even the best trading rule does not generate a mean net return larger than zero. White reality check is constructed on the following m1 performance statistic: ,

Comment [L3]: Ga er aan proberen te werken in cottage. Vader van mijn lief heeft ook finance gedaan, dus misschie kan hij helpen. Zoniet dit

where it is assumed that

). Indicates convergence in distribution as

and equals the following variance-covariance matrix:

) It

also has to be noted that the null hypothesis mentioned above is in fact a composite hypothesis with an asymptotic distribution that typically depends on nuisance parameters and is not uniquely identified. To resolve this issue, White (2000) imposes the least favorable configuration (LFC), the points on the null least favorable to the alternative, on the null (Park and Irwin, 2010). We define the points under the LFC as k=0 for all k. Now, the asymptotic behavior of the following test statistic , is known, and by using the observations of Yk,t where t=1,,N we can obtain an asymptotic pvalue for the test of the null hypothesis. In order to find the asymptotic behavior of the test statistics, the stationary bootstrap of Politis & Romano (1994) is used to resample from the original series4. The number of bootstraps is again 500. Note that this time we are not bootstrapping the buy and sell signals but instead the returns. The resampled performance statistic of each trading rule can be calculated as:


( )

and ( ) is a random index generated by the resampling algorithm. ( )

Given that the proper conditions are fulfilled the distribution, the distribution of converges to the distribution of ( ) ( ). ( ) as N increases (Politis and Romano, 1994):

The algorithm used can be found in appendix A

To estimate the desired distribution of (

) we draw multiple realizations of


Finally, the p-value for Whites Reality Check prc can be obtained by comparing Trc to the quantiles of: . /.

For b=1,,B and B is the number of bootstrapped series generated. Following Sullivan, Timmerman & White (1999), Cheng, Huang & Lai (2009) and Park and Irwin (2010) we set B equal to 500. The exact formula for calculating the p-value is (Park and Irwin, 2010):
* +

where again, 1{} is an indicator function that equals one if the expression between brackets is true and zero otherwise and the null hypothesis is rejected at the % significance level if prc (/100). Henriksson-Merton model Although the Henriksson-Merton (1981) is mainly used to test the superior forecasting skills of mutual fund managers, it can also have applications for trading rules. The basic concept is that successful market timing activities are interpreted as protective put options on the market index5. Henriksson & Merton (1981) model the time-varying exposure to market risk in a binary dependence of the market return (Krimm et al., 2009): ( ) ( ),

where Rt is the portfolio return at time t, Rf,t is the risk free rate and Rm,t is the market return. For reasons we already mentioned, we set the risk free rate on the left hand side equal to 0. The coefficient we are particularly interested in and which we report in our results is , which is positive

It is also possible to interpret market timing activities as calls on the market index (Henriksson, 1984).

and significant when there are successful market timing activities. Since this method does not specifically account for data snooping, it is only used as an extra robustness check for Whites Reality Check.

Limitations Tests of the protability of technical trading rules in futures markets (e.g., Stevenson and Bear, 1970) usually rely on the assumption that returns are stationary, independent, and normally distributed. There is very strong evidence that the distributions of stock index futures returns are leptokurtic, i.e. a sharp peak at the mean value, with fat tails, and weaker evidence that the returns are positively skewed. (Sutcliffe, 2006; Lukac & Brorsen, 1990) In such a case, MacKinnon (2006) urges caution on the accuracy of inferences made with the bootstrap, although he notes that when used for testing and for construction of percentile condence intervals, block-bootstraps frequently offer higher-order accuracy than asymptotic methods. The specific weakness of Whites Reality Check is the assumption that the entire universe of trading rules consists of only those we test (Szakmary et al, 2010). Furthermore, Hansen also noted that Whites Reality Check is influenced by irrelevant alternatives, which might lead to underestimating p-values and might put into question inferences from its results due to resultant fat tails in the p-value distribution (Hansen, 2005). However, the number of trading rules we use does not fall outside of the range used in other widely cited papers and we include additional measures to check our results against in the form of a normal block-bootstrap and the Henriksson-Merton Market Timing model regression, which do not make this assumption (Sullivan, Timmerman & White, 1999). Before we go on to describe our full universe of trading rules, several further comments related to practical issues have to be made. First and foremost, we tried to include the most commonly used trading rules, but due to the computer intensive methods we used and limitations on the resources available to us, we limited this research to 8 different kinds. Furthermore, of those 8 kinds, the majority is based on the same principles. By using 8 different kinds of strategies and letting those parameters vary, we therefore increased the number of rules. However, one might have the impression that this enlarges the chance of data snooping. Paradoxically, only by including a

sufficient number of rules can one achieve reliable p-values while using Whites Reality Check (2001), which specifically accounts for this data snooping problem. (Sullivan, Timmerman and White, 2001). Besides this, Datastream only provides datasets consisting of closing prices. We therefore assume that investors make their transaction at the end of the trading day at the closing price, i.e. at the same price as the most recent input into the trading rule. However, current research is undecided on the effect of intraday data on profitability, cautiously signaling that a different trading approach might be needed between daily data and intraday data6. This would render the issue moot (Sutcliffe, 2006). Using closing prices does diminish the possible delayed transaction limitations of trading systems compared to intraday transactions, although it certainly does not eliminate them and is dependent on the resources of the investor. For our other assumptions, we follow Park and Irwin (2010) in theirs: (1) all trading is on a onecontract basis, which eliminates non-synchronous biases that may arise from trading in stocks that try to emulate the composition of an index; (2) no reinvestments of profits are allowed7; and (3) enough funds are available to meet the margin requirements when trading losses occur.

Comment [PV4]: So you just save your wins/losses into a non-interest-bearin bank account? Do you annualize? How?

For example: different parameters or the presence of certain specific effects like the morning spike in intraday trading where stocks commonly overreact in the first quarter of the day before settling back to the mean. 7 As noted earlier, we futures involve zero initial investment and we calculate continuously compounded log returns assuming constant contract size.

Empirical results and discussion


We set out in this study to test empirically the profitability of technical analysis in nine stock market index futures markets from January 2000 to December 2010, taking into account data snooping biases, transaction costs and risks. Table 1 reports summary statistics on the monthly returns. Table 2a and Table 2b report the monthly returns, Whites Reality Check p-values and Sharpe ratios for the best trading rules in each market, further segmented along transaction costs and time period. When applicable, values are given for both subperiods to visualize evolution of the best performing trading rules. Significance in the two bootstrap methods and the Henriksson-Merton model is denoted (see footnotes). Summary statistics on skewness, kurtosis, volatility and higher order autocorrelations are not significantly different from those reported in other papers. More unexpected findings, meaning contrary to earlier research, are the absence of first order autocorrelations and the presence of negative mean returns in some markets, notably in the PSI20 and Bel20, even though returns on the best performing trading rules in Table 2a and 2b show strong positive and significant returns in the total time period (Brock et al, 1992; Bessimbinder and Chan, 1995; Cheng, Huang & Lai, 2009). Significant profits were thereby made despite a light negative trend. Figure 3 shows that returns for trading rules are correlated across time periods, with a higher correlation for better performing trading rules. Sharpe ratios are lower in subperiod 2 than in subperiod 1, where Figure 1 and 2 show that returns are not necessarily so and returns in subperiod 2 tend to even be higher than those in subperiod 1. Table 2a and Table 2b show significant support of a trading rule approach in Portugals PSI-20 to achieve positive returns in all periods, with strongly significant Reality Check p-values, additional support from the block bootstrap and the Henriksson-Merton model and demonstrated consistency

in significant profits when looking at the corresponding subperiod. The Bux market also shows convincing evidence for significant positive returns in subperiod 1 and the total period, while the BEL20 shows some less convincing evidence and lacks consistency when comparing the best performing trading rules in subperiod 2 with their results in subperiod 1. Remark in Table 2a and 2b that these three markets have the highest relative Sharpe ratios, with those of the best performing trading rules in the PSI20 approaching unity. Finally, Table 4 reports that these three markets are also the smallest by volume. Descriptive results
Mean (%) Bel20 Bovespa Bux Hangseng Ibex Kospi Nikkei Psi20 SP500 -0,15% 1,46% 0,97% 0,40% 0,08% 1,42% -0,29% -0,29% -0,06% Skewnes s Kurtosis -0,077 -0,123 -0,014 0,010 0,114 -0,343 -0,150 0,084 0,045 10,58 5,47 10,43 9,31 9,76 6,80 16,45 17,54 14,21

S.D. 0,014 0,020 0,016 0,017 0,015 0,017 0,016 0,012 0,014

(1) 0,030 -0,002 0,046**

(2) -0,011 -0,038* -0,074**

(3) -0,029 -0,041** 0,016 -0,005 -0,044** 0,015 -0,015 0,007 0,023

constant -0,0000629 0,0005922 0,0004001 0,0001675 0,0000103 0,0005364 -0,0001276 -0,0001206 -0,000031

-0,046** -0,017 -0,032 -0,027 -0,046** -0,008

-0,047** -0,084** 0,033* -0,004

-0,077** -0,080**

Table 1: Summary Statistics on monthly returns of selected stock index futures markets Following reporting methods used by Cheng, Huang & Lai (2009) and Park & Irwin (2010), we only display the results in Table 2a and 2b for the best performing rule over each researched time period for each contract. The reasoning being that as future markets are inherently risky due to their leverage properties, investors engaging in this market are unlikely to base their ranking of methods on the highest sharpe ratio and more likely to base it on potential returns. We adopt a minimum 10% significance level in highlighting significant p-values. This cutoff point indicates that we consider a trading rule to be significant when, in the researched period, less

than 50 of the 500 randomly generated bootstrap series produced a best-performing trading rule that showed higher returns.

Bel20 R R other period RC p-value Sharpe ratio Bovespa R R other period RC p-value Sharpe ratio Bux R R other period RC p-value Sharpe ratio Hangseng R R other period RC p-value Sharpe ratio Ibex R R other period RC p-value Sharpe ratio

Subperiod 1 No TC wma(50,200) 1,01%* 1,10% 0,396 0,71 wma(50,200) 0,99% 0,51% 0,792 0,6 wma(15,50) 1,45%*** 0,95% 0,008 0,76 ma(15,50) 0,77%* 0,66% 0,774 0,38 ema(50,200) 0,71% 0,28% 0,976 0,37

TC 0,0025 wma(50,200) 1,00%* 1,08% 0,412 0,70 wma(50,200) 0,98% 0,48% 0,812 0,59 wma(15,50) 1,42%*** 0,90% 0,012 0,74 ma(15,50) 0,71%* 0,61% 0,864 0,35 ema(50,200) 0,70% 0,26% 0,984 0,37

TC 0,005 wma(50,200) 0,99%* 1,07% 0,424 0,70 wma(50,200) 0,97% 0,45% 0,822 0,58 wma(15,50) 1,38%*** 0,84% 0,014 0,72 ma(15,50) 0,67%* 0,56% 0,888 0,33 ema(50,200) 0,70% 0,25% 0,984 0,37

Subperiod 2 No TC mom(50,9) 1,39%** -0,80% 0,072 0,57 ma(50,200) 1,15% 0,17% 0,988 0,38 mom(5,9) 1,56%* 0,34% 0,218 0,51 Combination 1,35%* n/a 0,44 0,38 wma(15,200) 0,97%* -0,57% 0,902 0,37

TC 0,0025 mom(50,9) 1,15%* -2,16% 0,23 0,47 ma(50,200) 1,14% 0,15% 0,992 0,38 Combination 1,36% n/a 0,366 0,45 Combination 1,33%* n/a 0,476 0,37 wma(15,200) 0,95%* -0,65% 0,908 0,36

TC 0,005 wma(50,200) 1,07% 0,99%* 0,31 0,44 ma(50,200) 1,13% 0,13% 0,994 0,38 Combination 1,34% n/a 0,404 0,44 Combination 1,31%* n/a 0,508 0,37 wma(15,200) 0,93%* -0,74% 0,916 0,35

Total Period No TC wma(50,200) 0,86%*** 0,018 0,40 ema(15,200) 0,65% 0,938 0,22 ma(15,200) 0,96%*** 0,006 0,38 ema(15,50) 0,69%* 0,492 0,26 ema(50,200) 0,54% 0,918 0,47

TC 0,0025 wma(50,200) 0,86%*** 0,032 0,40 ema(15,200) 0,64% 0,942 0,22 ma(15,200) 0,95%*** 0,022 0,38 ema(15,50) 0,66%* 0,556 0,25 ema(50,200) 0,54% 0,94 0,47

TC 0,005 wma(50,200) 0,85%*** 0,038 0,40 pc(50) 0,63% 0,952 0,21 ma(15,200) 0,95%*** 0,026 0,38 ema(15,50) 0,64%* 0,61 0,24 ema(50,200) 0,53% 0,944 0,46

Table 2a: Best performing trade rule monthly returns, Whites Reality Check p-values and Sharpe ratios

* Block Bootstrap Method significant < 0,1 ** Reality Checke significant <0,1, only relevant for period indicated by column header *** Reality Check significant < 0,05, only relevant for period indicated by column header Bold when Henriksson Merton Model significant and positive

Kospi R R other period RC p-value Sharpe ratio Nikkei R R other period RC p-value Sharpe ratio Psi20 R R other period RC p-value Sharpe ratio SP500 R R other period RC p-value Sharpe ratio

Subperiod 1 No TC ema(5,50) 1,36%* 0,65% 0,118 0,49 ma(5,200) 0,72% 0,68% 0,86 0,41 ma(5,50) 1,27%****** 1,28%* 0,004 0,91 ema(50,200) 0,55% 0,42% 0,974 0,35

TC 0,0025 ema(5,50) 1,33%* 0,59% 0,216 0,48 ma(5,200) 0,70% 0,65% 0,916 0,40 ma(5,50) 1,23%*** 1,22%* 0,01 0,88 ema(50,200) 0,55% 0,41% 0,986 0,35

TC 0,005 ema(5,50) 1,30%* 0,54% 0,246 0,47 ma(5,200) 0,68% 0,62% 0,922 0,38 ma(5,50) 1,18%*** 1,17%* 0,02 0,85 ema(50,200) 0,55% 0,39% 0,986 0,34

Subperiod 2 No TC ema(5,200) 1,10%* 1,03% 0,832 0,43 macd(12,26) 0,98%* 0,17% 0,832 0,35 ema(5,15) 1,40%*** 1,04%* 0,014 0,63 ma(15,200) 0,90% -0,32% 0,994 0,37

TC 0,0025 ema(5,200) 1,09%* 1,01% 0,838 0,43 macd(12,26) 0,87%* -0,03% 0,904 0,31 ema(5,15) 1,34%*** 0,95%* 0,02 0,60 ma(15,200) 0,88% -0,37% 0,996 0,36

TC 0,005 ema(5,200) 1,08%* 1,00% 0,85 0,42 ma(15,200) 0,78% 0,57% 0,948 0,28 Combination 1,28%*** n/a 0,046 0,58 ma(15,200) 0,87% -0,44% 0,996 0,36

Total Period No TC wma(15,200) 0,84%* 0,154 0,64 ma(15,200) 0,59%* 0,85 0,23 ma(5,50) 1,02%*** 0 0,55 ema(50,200) 0,47% 0,994 0,23

TC 0,0025 wma(15,200) 0,83%* 0,244 0,63 ma(15,200) 0,57%* 0,986 0,22 ma(5,50) 0,99%*** 0,002 0,53 ema(50,200) 0,47% 1 0,23

TC 0,005 wma(15,200) 0,82%* 0,262 0,62 ma(15,200) 0,56%* 0,986 0,22 ma(5,50) 0,96%*** 0,006 0,52 ema(50,200) 0,46% 1 0,22

Table 2b: Best performing trade rule monthly returns, Whites Reality Check p-values and Sharpe ratios

* Block Bootstrap Method significant < 0,1 ** Reality Checke significant <0,1, only relevant for period indicated by column header *** Reality Check significant < 0,05, only relevant for period indicated by column header Bold when Henriksson Merton Model significant and positive

Analysis of the Results When comparing the time periods, we find that none of the best performing trading rules carries on as the best performing from subperiod 1 to subperiod 2. This might indicate a need for a less stringent test, although Figure 3 does show that returns from the subperiods follow a concave function together with the returns of the total period, especially for the better-performing rules. The majority of best performing rules in subperiod 1 carry on to the total period, although this is hardly surprising. Divergence in returns in subperiod 2 reflects the higher volatility in times of financial crisis. Comparing yearly returns, we find that the mean return is highest in Subperiod 2 relative to Subperiod 1 and the total period whether calculated from (i) all trading rules (14,28% against 12,04% and 10,7% respectively), or (ii) only those significant with both p(bbm) < 0,10 and p(mc) < 0,10 (14, 34% against 11,94% and 10,73% respectively), or (iii) only those significant on the 10% level in Whites Reality Check (16,74% against 16,33% and 11,38% respectively). Also to be noted is that the total period does worst on all measures. When finally looking at the significance of our results, we find only one market that is (highly) significant on all levels in each time series, with the exception of significance in the HenrikssonMerton model in subperiod 2: Portugals PSI-20. This is followed by the BUX, which performs less convincingly in subperiod 2; lastly there is weak evidence for profitability on the BEL20. All other markets lack any credible indication that trading rules might be profitable when accounting for both data snooping and transaction costs. We find that many trading rules do have significant block bootstrap p-values while far less rules have positive significant values using the Henriksson-Merton model, which indicates the extent of the data snooping problem on the discovery of profitable trading rules using regular resampling techniques10.
Comment [PV5]: Total is always (p1+p2)/2uitleggen?!? Snap niet wat hij hiermee bedoelt


The authors note that they also programmed a monte carlo simulation, which resulted in roughly the same lack of stringency and provided little value over the block bootstrap model and was therefore dropped from the main analysis.

Transaction costs seem to have a linear effect on the profitability of trading rules. They do not generally affect the returns to the extent that they change their sign, but they do seem to affect some trading rules more than others. We see this easily in a few cases on table 2a and 2b, notably in subperiod 2, where higher transaction costs affect the return of the no-transaction-cost best-trading rule relatively more. This produces a new best trading rule, on which Whites Reality Check was then applied. Also, as one may suspect, the combination rule performs relatively better as transactions rise in markets, especially in the more volatile subperiod 2. It is inherently more conservative, as the combined signal approach implies a weighted signal that is less likely to overreact to new information, making a switch in position less likely and thus having a relatively reduced number of transactions and therefore also transaction costs. The combination rule also show moderate amount of support when we look at the calculated p-values from our bootstrap test. Sharpe ratios are remarkably higher in subperiod 1 than in the other periods, with the trading rule in PSI-20 reaching an extremely high value of 0,91 compared to a 5- year Sharpe ratio of the PSI-20 index of 0,33. Taking the example of the PSI-20, this drops down to a ratio of 0,63 and 0,64 in subperiod 2 and the total period, respectively. The full weight of this change lies on the volatility of the markets, as mean returns in subperiod 2 are higher than in subperiod 1.

No TC R1

Bel20 Bovespa Bux Hangseng Ibex Kospi Nikkei Psi20 SP500 0,72% 0,20% 1,21% 0,12% -0,78% 0,96% 0,72% 0,84% -0,03%

R2 P BBM 1 P BBM 2 Rank1 Rank 2 TC 0,0025 R1 R2 Rank 1 Rank 2 TC 0,005 R1 R2 Rank 1 Rank 2

0,93% 0,156 0,17 10 7 0,56% 0,90% 11 7 0,43% 0,87% 13 7

0,41% 0,41 0,442 14 15 -0,03% 0,36% 20 14 -0,27% 0,31% 21 13

1,39% 0,032 0,07 7 2 0,97% 1,36% 13 1 0,86% 1,34% 18 1

1,35% 0,45 0,08 13 1 -0,28% 1,33% 21 1 -0,64% 1,31% 25 1

0,92% 0,74 0,086 27 2 -0,14% 0,90% 14 2 -0,22% 0,87% 14 2

0,86% 0,158 0,148 9 7 1,18% 0,83% 5 7 1,09% 0,80% 5 7

0,66% 0,12 0,198 2 6 0,55% 0,62% 3 8 0,41% 0,57% 3 7

1,31% 0,096 0,074 10 3 0,82% 1,30% 10 2 0,68% 1,28% 10 1

0,77% 0,48 0,17 16 7 -0,35% 0,73% 23 7 -0,69% 0,69% 25 6

Table 3 Combination rule monthly returns analysis In subperiod 1 and the total period, we used a combination of inputs from all trading rules to add another trading rule. The subperiod 2 combination rule only contained the best performing trading rules however. This calibrated trading rule performs better than the encompassing rule in subperiod 1 and is notable for being the best performing trading rule in some markets, or becoming it when transaction costs rise.

Figure 1: Comparison returns of trading rules across time periods in BEL20

Figure 2: Comparison returns of trading rules across time periods in PSI20

Figure 1: Comparison returns of trading rules across time periods in all information sets



Summing up the empirical information, we confront our results with our original research question: Is an investor using Technical Analaysis systematically capable of generating significant abnormal returns in inefficient index futures markets? H1: Technical analysis does not produce significant abnormal returns in stock market index futures As a prelude to answering our main hypothesis, we note that the results produced under Whites Reality Check are the only ones that can be interpreted under the full constraints of our hypotheses pertaining to data snooping and transaction costs. Although we collect and represent results under the block bootstrap method and the Henriksson-Merton market-timing model to raise the credibility of our results, Whites Reality Check itself only produces p-values for the best performing trading rule in each market. This in combination with the low number of markets we could research limits our conclusions to profitability of trading rules in certain stock index futures markets and excludes any speculation on which trading rule would be proportionally better to apply in all futures markets. Turning towards the significance of results generated through technical analysis in our small set of markets therefore, we find one market that produced significant and positive returns in practically all tests in all periods and two markets in all tests but in one of the subperiods and also the total period. While on preliminary sight this result under strong constraints seems on average meek, it does strongly reject our first hypothesis allowing us to argue that technical analysis does produce significant abnormal returns in stock market index futures. H1a: Technical analysis does not produce significant abnormal returns in stock market index futures when accounting for data snooping. When comparing results between our three significance tests, we find that the Block Bootstrap Method overestimates the significance of trading rules in cases where both our regression model

and Whites Reality Check find none. If the latter tests agree where the Block Bootstrap does not, this must be to a certain extent attributable to data-snooping bias as Whites RC is partly designed (and limited in information value because of it) to negate this bias (White, 2000), while the Hendrikkson-Merton market-timing model does not reuse the same dataset over and over like resampling methods do and makes it less susceptible to data-snooping. The size of the datasnooping effect is outside of the scope of this paper however as research on it requires extensive out-of-sample testing. In any case, the presence of data-snooping does nothing to detract from our results obtained through Whites Reality Check, further supported by the HMMT, and the conclusions from our main hypothesis hold for the best performing trading rules while our decision to put in doubt the results produced by the less stringent BBM is confirmed. H1b: Technical analysis does not produce significant abnormal returns in stock market index futures when accounting for transaction costs Finally, transaction costs obviously play a role in the profitability of trading rules, especially when rules are used with a short horizon. This explains the particular ascendance of our combination rule in the volatile subperiod 2 when transaction costs rise as fewer transactions are made compared to the uncombined rules that react too quickly to reversing data because the latter lack any counterweight and thus greatly decline in profitability as transaction costs rise. Nonetheless, transaction costs do not wipe out the significant abnormal returns generated in a market using a mechanical trading system, even when using single indicator signals, and we can reject the hypothesis. In sum we thus conclude that technical analysis does produce significant abnormal returns in some stock market index futures when taking into account data snooping and transaction costs.

H2: Results will be more significant in smaller, less developed markets. On an observation basis, we find some support for our hypothesis that results are more significant in smaller, less developed markets. Looking at the characteristics of our three markets that turn out significant returns on Whites Reality check, we observe that both the BUX and PSI20 are the smallest market in capitalization value in our sample by some margin, although the BEL20 is, by our standards, a medium sized market. In addition, Table 4 shows that these three index futures are the lowest traded securities among all nine securities. This seems to be some indication, together with earlier studies, that in smaller and particularly less developed markets, noting the less convincing results in the BEL20, technical analysis is a valid trading strategy. Equally, it could also mean that in small markets, illiquidity and price pressure are so high that traders do not even try to eliminate before-cost predictability. We remain even more cautious towards this conclusion due to lack of significance tests, the low number of markets and the presence of development with both the PSI 20 and the BEL 20 being part of the Euronext operator.
Volume Traded KOSPI 200 S&P 500 HANG SENG BOVESPA IBEX 35 NIKKEI 225 BUX BEL 20 PSI 20 Subperiod 1 188773 77694 27987 24227 16620 3882 1553 1776 1034 Subperiod 2 261393 52110 75507 76798 26759 13116 12803 1830 376 Total Period 225112 64928 51669 50299 21695 8480 7169 1803 705

Table 4: Average Volume Traded per day H3a: Significant positive returns in stock index futures markets are made both in a bull market as in a bear market. We find evidence supporting this hypothesis in the fact that the PSI market has a negative mean return over the total period, while the BUX market has a positive mean. Both markets show

convincing support towards significant abnormal returns, by this we find that mechanical trading rules can be profitable in both a bear and a bull market. H3b: There is a correlation between returns of trading rules across time periods. Figure 3, a graph depicting all trading rules in all markets across the 2 time periods, shows a persistence of relative returns. Note how the three logarithmic trend lines drawn for each time period diverge very little and contract when returns rise. The same observation can be noted in figure 1 and 2. This provides evidence towards consistency of trading rules over time periods. As this is especially true for trading rules with higher returns, we cautiously indicate that perhaps there is a trading rule or a number of trading rules that consistently achieve better results than others. H3c: Any significant return during a bear market will have a lower Sharpe ratio than in a similar bull market with equally significant returns. Looking at Table 2a and 2b, we find that this is indeed the case. Returns in subperiod 2, where markets have a lower mean return than in subperiod 1, are not significantly different from those in subperiod 1. Yet, we find that the Sharpe is consistently lower in the former period. As the risk free rate remains constant, we can only surmise that the late 2000s financial crisis caused a higher volatility, which raised the risk of investing. We also noted that returns in subperiod 2 seem to be generally higher, although more volatile, suggesting a superiority of technical analysis in volatile market phases.



This study empirically tested nine stock index futures markets on the profitability of mechanical trading rules, accounting for data snooping bias, transaction costs and risk, using Whites Reality Check methodology in combination with a Block Bootstrap method and a Henriksson-Merton market timing model. Strong significant abnormal returns in two markets, the PSI20 and the BUX, were found on the best performing trading rules. These markets displayed relatively smaller volumes in daily transactions and distinguished themselves from a third market displaying less convincing significant returns, the BEL20, by being less developed measured by market capitalization of the relevant stock market. Abnormal returns using trading rules held under changing market conditions and different time periods. All other markets strongly rejected the notion of significant abnormal returns using technical analysis and confirmed to the Efficient Market Hypothesis. Future research might concentrate on the inclusion of more security markets, particularly more recent ones, by using shorter time periods. This would help research on newer, less developed and less efficient markets paving the way to more evidence against the EMH.


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This appendix describes the resampling technique of Politis and Romano (1994) named the Stationary Bootstrap. We used a resampled version of :

to calculate the p-value of the Reality Check. The resampled statistic equals:


( )

and ( ) is a random index generated according to the Politis and Romano

stationary bootstrap algorithm. This algorithm requires us to define a smoothing parameter q which fulfills the following conditions: and

Again following Sullivan, Timmerman and White (1999) we set q equal to 0.10, although they show that values of 0.01 or 0.5 almost yield identical results. We now proceed as follows: 1) Set t=1. Draw ( ) at random, independently and uniformly from {1,,N} 2) t = t+1 a. Stop if t>N b. Draw a random standard uniform variable with if t<N If If < q, draw ( ) at random, independently and uniformly from {1,,N} q, expand the block by setting ( ) = ( ) +1

3) Repeat step 2.