Almgren, Robert. Bertsimas, Dimitris and Andrew W Lo. Bollerslev, Tim and Michael Melvin. Bowman, Adrian W and Adelchi Azzalini. Oxford University Press. Burnside, Craig. Handbook of Exchange Rates, chap. Carry Trades and Risk.
Cushing, David and Ananth Madhavan. Evans, Martin D. Exchange-Rate Dynamics. Princeton Series in International Finance. Princeton University Press. Gagnon, Joseph E et al. Hart, Oliver D. Hendershott, Terrence and Albert J. Hillion, Pierre and Matti Suominen. Ito, Takatoshi, Richard K. Lyons, and Michael T. I remember you started off with a study of head-and-shoulders patterns.
Can you describe that study? I looked at whether head-and-shoulders patterns are useful for predicting exchange rate movements, using daily exchange rates over about 20 years. We found that head-and-shoulders patterns were pretty useful for forecasting exchange rate movements. But when we looked at it more closely, we found that you could actually do a lot better using much simpler technical tools, such as moving averages or filter rules.
The head-and-shoulders strategy overlapped strongly with the others in terms of the positions they recommended, but the simpler technical rules were more frequently right. So we argued that the head-and-shoulders strategy, while potentially useful if there was nothing else available, was what we refer to as dominated by the much simpler rules. In the abstract of another paper, you reported that head-and-shoulders trading is generally unprofitable.
In that paper, titled "Identifying Noise Traders: The Head-And-Shoulders Pattern in US Equities," I looked at the stock market and came to a very different conclusion about the usefulness of the head-and-shoulders pattern. I looked at daily stock prices for different firms, which I chose at random.
First of all, I asked: Are head-and-shoulders patterns profitable in the stock market? I found that on average, they absolutely are not. So then I wondered whether there was active trading on this pattern that does not seem to be profitable in the equities markets.
I was able to show statistically that there's a lot of extra trading volume right around the time my analysis says people should be taking positions. And the extra trading volume peaks on the exact day I think people should be taking positions, and then it tapers off over the next few days, just as I would have expected. So it sure looks like people are trading on head-and-shoulders patterns, but on average they are not getting much out of it in equities markets.
What do you suppose is the difference in the markets here? Stocks versus foreign exchange? That's a really good question. A lot of people in the market think it might be a self-fulfilling prophecy; the more technical trading there is, the more it makes profitable patterns, so the more that people trade on it.
It's my impression that there is more technical trading in the foreign exchange market, so it could be self-fulfilling. Somehow, I think there has to be more going on.
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