- some of the commonly used technical methods for predicting market direction
- some modern approaches to modeling markets and their microstructure
Technical analysis
Technical analysis is a way of predicting future price movements based only on observing the past history of prices. Technical analysis is also called charting because the graphical representation of prices etc. plays an important part. Technical analysis is good for timing market moves.
Fundamental analysis is contrast method. It is based on an examination of the factors underlying the stock or other instrument. Fundamental analysis is good to know the market direction, but not effective when the market moves.
Support and resistance
Resistance is a price level which an asset seems to have difficulty rising above. This may be a previously realized highest value, or it may be a psychologically important (round) number.
Support is a level below which an asset price seems to be reluctant to fall. There may be sufficient demand at this low price to stop it falling any further.
Trendlines
Trendlines are formed by joining together successive peaks and/or trough in the price history to form a rising or falling support or resistance level.
Moving averages
Moving averages are calculated in many ways.
- different time windows
- exponentially weighted averages
Moving averages are supposed to distill out the basic trend in a price by smoothing the random noise.
There is some evidence that there may be predictive power in moving averages.
Relative strength
The relative strength index is the percentage of up moves in the last N days.
Oscillators
\[ 100 \times \frac{\text{current close} - \text{lowest over n periods}}{\text{highest over n periods} - \text{lowest over n periods}} \]
Bollinger bands
Bollinger bands are plots of a specified number of standard deviations above and below a specified moving average.
Miscellaneous patterns
Japanese candlesticks
Points and figure charts
For each consecutive asset price rise of the box size draw an ‘X’ in the box, in a rising column, one above the other. When this uptrend finished, and the asset falls, start putting ‘O’ in a descending column, to the right of the previous rising Xs.
- A long column of Xs denotes demand exceeding supply
- A long column of Os denotes supply exceeding demand
- Short up and down columns denote a balance of supply and demand
Wave theory
Elliott waves and Fibonacci numbers
Gann charts
Other analytics
Volume is the number of contracts traded in a given period. A rising price and high volume means a strong, upwardly trending market. But a rising price with low volume could be a sign that the market is about to turn.
Open interest is the number of still outstanding futures contracts, those which have not been closed out. Because there are equal numbers of buyers and sellers, open interest does not necessarily give any directional info, but an increase in open interest can mean that an existing trend is strong.
Market microstructure modeling
Market players
- Producers: manufacturing or producing or selling various goods and being involved in the financial markets for hedging
- Speculator: trying and spotting trends in the market to exploit them and make money
- Market makers: buying and selling financial instruments, holding them for a very short time, often seconds, and profiting on bid-ask spreads
There have been many attempts to model the interaction of these agents, sometimes in a game theoretic way.
Effect of demand on price
A common starting point is to assume that there are 2 types of trader and one market maker. One trader follows a technical trading rule such as watching a moving average and the other is a noise trader who randomly buys or sells.
- trend followers can induce patterns in asset price time series;
- these artificially patterns can only be exploited for gain by someone following a suitably different trend;
- the more people following the same trend as you, the more money you will lose
reason for there being genuine trends in the market
- There is a slow diffusion of information from the knowledgeable to the less knowledgeable; The piece-by-piece secret acquisition of a company will gradually move a stock price upwards
reason for there not being genuine reason for a trend
- If it is simply a case of trend followers begetting a trend, then it may be beneficial to be a contrarian
Combining market microstructure and option theory
Arbitrage does exist; many people make money from its existence. But there will be a timescale associated with this removal. What is the optimal way to exploit the arbitrage opportunity while knowing that your actions will to some extent be self-defeating?
Imitation
Another approach to market microstructure modeling is based on the true observation that people copy each other. In these models there are a number of traders who act partly in response to private information about a stock, partly randomly as noise traders, and partly to imitate their nearest neighbors. These models can result in market bubbles or market crashes.
Crisis prediction
Some ideas from earthquake modeling, ‘Richter.’
An effective predictor of market crashes could either:
- increase the chance or size of a crash as everyone panics, or
- reduce the chance or size of the crash since everyone gets advance warning and can calmly and logically act accordingly
Further reading
