Profitability of technical stock trading: Has it moved from daily to intraday data

1. Introduction

In the recent debates over the informational (in)efficiency of the stock market, particular attention has been paid to two “anomalies,” the momentum and reversal effects. The first effect refers to the phenomenon of stock price trends that can be profitably exploited by following “momentum strategies” (Fama & French, 1989; Jegadeesh & Titman, 1993; Chan, Jegadeesh, & Lakonishok, 1996; Goetzmann & Massa, 2002); the second refers to reversals in stock price trends that can be profitably exploited following “contrarian strategies” (DeBondt & Thaler, 1985, 1987; Fama & French, 1989; Jegadeesh, 1990; Lo & MacKinlay, 1990; Lehman, 1990).

All these studies investigate the profitability of hypothetical trading rules that are most probably not used in practice, at least not systematically. However, market participants use a great variety of trading techniques to exploit asset price trends and their reversals, i.e., the trend-following and contrarian models of technical analysis.

Technical analysis is omnipresent in financial markets. In the foreign exchange market, e. g., technical analysis is the most widely used trading technique (for recent survey studies see Taylor & Allen,1992; Cheung & Wong, 2000; Cheung & Chinn, 2001; Oberlechner, 2001; Cheung, Chinn, & Marsh, 2004; Gehrig & Menkhoff, 2004, 2005, 2006; Menkhoff & Taylor, 2007). It seems highly plausible that technical analysis plays a similar role in stock markets, particularly in short-term trading in stock futures (Irwin & Holt, 2004, provide evidence about the popularity of technical analysis in futures markets).

The omnipresence of technical analysis in financial markets presents a dilemma for conventional asset market theory. If technical trading is not profitable, then the assumption of market participants' rationality is in doubt, whereas, if technical analysis is actually profitable, then the assumption of (weak-form) market efficiency is in doubt.

Many empirical studies of the performance of technical trading systems in the stock and foreign exchange markets report that these trading techniques would have been abnormally profitable.^[1] The results of these studies have not, on the whole, been taken seriously by the economists' profession. There might be several reasons for that. First, if one accepted the excessive profitability of technical analysis as a feature of asset markets then fundamental concepts like market efficiency or rational expectations would have to be seriously reconsidered (see the “Adaptive Market Hypothesis” of Lo, 2004, as example of an alternative approach). Second, recent studies—all based on daily data—find that the profitability of technical analysis has strongly declined or even ceased to exist in the stock market (Sullivan, Timmermann, & White,1999), in the foreign exchange market (Neely, Weller, & Ulrich, 2008; Olson, 2004; Schulmeister,2008a,b)aswellasinmanyfutures markets (Park&Irwin, 2005). This could be viewed as confirmation that their excessive returns were onlya temporary phenomenon. Finally, most studies reported only asmall numberof profitable rules, whichmaderesearchers suspiciousof “data mining.” That is, researchers might have tested a large number of rules and found that somewere profitable purely bychance (this issue is investigated by Sullivan, Timmermann, & White, 1999, and by Neely et al., 2008).