Profitability Of Technical Analysis: A challenge of Market Efficiency

Mr.Fred K.H. Tam wrote “Profitability Of Technical Analysis: A challenge of Market Efficiency” in 2006. Mr.Fred K.H. Tam is an experienced trader, a knowledgeable technical analyst, a serious and scientific student of the stock market and an inspiring educator. These desirable characteristics of Mr. Tam gathered together to help him write this significant contribution to the world’s literature on financial markets and to offer practical applications of technical trading tools for trading or investing in the Malaysian stock market.

This book makes three special contributions to the study of financial markets. First, it provides a rigorous recapitulation of the Efficient Market Hypotheses (EMH) theory, which sets the stage for a presentation of the anomalies and the detractors that have beset the EMH during recent years. Second, the book reports the finding of a comprehensively designed and carefully executed empirical study of the Malaysian stock market.

From a step-by-step filtering process, there emerges from this research several robust and reliable technical
market analysis trading systems that offer the opportunity to traders and investors to earn above normal returns in the Malaysian stock market. The third unique contribution of this book to the field of investments is in the three case studies relating to special high-risk circumstances facing the Malaysian investor. The book offers insights into the unique character of each type of risk situation and it offers specially-crafted technical analysis approaches to cope with each such circumstance. This third contribution is like a sequel, an additional bonus, to the first two contributions of this book.

Background Brief

This book has been written to cater to the academician with an interest to establish if technical trading systems and technical analysis can make abnormal returns from the Malaysian stock market.

It is also written especially for analysts and fund managers desirous of using technical trading tools to time the entry into and exit out of stocks.
Last but not the least, this book is dedicated to the ordinary lay investor seeking for proven methods on how to invest profitably in stocks. It has in all nine chapters and is essentially split into two sections.

The first section comprising Chapters 1 to 6 covers a study made on 38 stocks listed on Bursa Malaysia. Under the ambit of technical analysis, 13 technical trading systems were used to analyse the behaviour of the stocks and conclusions drawn therefrom. Test results conclude that the Malaysian stock market is not a random walk, in other words, it is
inefficient. Of the 13 technical trading systems tested on the sample of the 38 stocks 6 of the technical trading systems consistently beat the market, namely, 1) the Channel Breakout 20 -20, 2) the Channel Breakout 20-10, 3) the Channel Breakout 20-5, 4) the Channel Breakout 15-5, 5) the Directional Movement Index (DMI) and 6) the 5-20 Simple Moving Average trading system.

The second section evolves from the first one involving the study of the 38 stocks, as, arising from the findings of the study, certain lessons were deduced from them and extended to apply to special situation stocks. The author has chosen to categorise these special situation stocks under Chapter 7 (Asian financial crisis from 1997 to 1998), Chapter 8
(limit-down stocks of 2005 from the bank margin squeeze) and Chapter 9 (bubble stocks) and has recommended strategies on how to manage each of them to minimise loss and maximise gain for the market player.

FIRST SECTION

CHAPTER 1: Introduction

• Overview
• Scope of This Book
  • First Section
  • Second Section

CHAPTER 2: Market Efficiency

• Introduction
• The Concept of Efficiency
• Dimensions of Market Efficiency
• Levels of Market Efficiency
  • Weak Form Efficiency
  • Semi-Strong Form Efficiency
  • Strong Form Efficiency
• The Value of an Efficient Market
• Efficient Market Hypothesis (EMH)
• Rationale of the EMH Theory
• Sufficient and Necessary Conditions
• Testing Mechanism for Market Efficiency
  • Testing the Weak From EMH
    • Statistical Test of Independence
    • Test of Trading Rules
  • Testing the Semi-strong Form EMH
    • Time Series Analysis
    • Event Study
    • Cross-sectional Distribution of Returns
  • Testing the Strong Form EMH
• Implications of Market Efficiency
• Summary

CHAPTER 3: Theoretical and Empirical Challenges to Market Efficiency

• Introduction
• Fundamental Analysis
  • Value Investing and the Book Value-Market Value Effect
  • The Dividend Signalling Effect
  • Size Effect or Small Firm Effect
  • Neglected Firm Effect
  • The Calendar Effect
  • Low P/E Effect
  • Summary
• Technical Analysis
  • Summary
• Behavioural Finance – An Alternative Theory of Market Behaviour
  • Contrarian Strategies or Overreaction Hypothesis
  • Momentum Strategies
  • Noise Trading
  • Summary

CHAPTER 4: Methodology and Data

• Introduction
• Theoretical Framework
• Methodology – Technical Trading Rules
• The 13 Technical Trading Systems and Rules
  • System 1 – The Single Simple Moving Average (SMA) Crossover Method
  • System 2 – The Dual Simple Moving Average Crossover Method
  • System 3 – Dual Exponential Moving Average (EMA) Crossover Method
  • System 4 – Relative Strength Index (RSI)
  • System 5 – Momentum
  • System 6 – Slow Stochastic
  • System 7 – Channel Breakout (CBO)
  • System 8 – Channel Breakout (CBO)
  • System 9 – Channel Breakout (CBO)
  • System 10 – Channel Breakout (CBO)
  • System 11 – Channel Breakout (CBO)
  • System 12 – Moving Average Convergence Divergence (MACD)
  • System 13 – Directional Movement Indicator (DMI)
• Reason for using shorter-term user-defined periods
• Data
  • Population of the Bursa Malaysia and Methodology in the Construction of
    the KLCI
  • Construction of the KLCI
  • Sampling Method and Sample Size
  • Sample Size
  • Test Period for the Study
• The Testable Hypotheses
  • Three Hypotheses
  • Transaction costs
  • Computation of the Risk-free (Rf) Rate
  • Statistical Tests

CHAPTER 5: Results and Findings

• Introduction
• First Test: Whether Gross Returns from Trading Systems Can Exceed Returns from the Buy-And-Hold Strategy – A Test of Random Walk
• Second Test: Whether Net Returns from Trading Systems (After Transaction Costs) can Exceed Returns from the Buy-And-Hold Strategy – A Traditional Test of Weak Form Efficiency
  • Sub-test 1: Hypothesis 2A (after 0.84 percent transaction cost)
  • Sub-Test 2: Hypothesis 2B (after 0.44 percent transaction cost)
• Third Test: Whether Risk-Adjusted Net Returns from Trading Systems (After Transaction Costs) Can Exceed Returns from the Buy-And-Hold Strategy – The Jensen Test of Weak Form Efficiency
• Ranking of Trading Systems Based on the Jensen Measure
• The Relative Return Measure: Overcoming the Pitfalls of Using the Capital Asset Pricing Model’s (CAPM) Orientated Beta to Identify Risk
• Ranking of Trading Systems Based on the Sharpe Measure
• Comparison between the Jensen and the Sharpe Measures
• Summary of Findings

CHAPTER 6: Conclusion

• Introduction
• Overview of Study
•  Summary of Findings
• Contributions of This Study
• Limitations of This Study and Directions for Future Research
• Case Study: Practical Application of the C.B.O. 20-20 Trading System to Trading Malaysian Stocks

SECOND SECTION

CHAPTER 7: Case Study: The Effectiveness of Technical Trading Systems During the Asian Financial Crisis of 1997-1998

• Introduction
• Background of the Asian Financial Crisis
• Results and Findings of the Asian Financial Crisis Period Test
• Case Studies of the KLCI and 12 KLCI Stocks During the Asian Financial Crisis

CHAPTER 8: Case Study: Limit-Down Stocks in 2005 Arising from the Bank Margin Squeeze

• Background Introduction
• Limit-Down Stocks Implicates Market Inefficiency
• The Importance of Price Information
• Effectiveness of Bursa Malaysia’s Unusual Market Activity (UMA) Queries on the Informational Efficiency of Malaysian Stocks
• Stock Manipulation
• Manipulated Stocks – Should One Play It?
• Manipulated Stocks – How to Handle It?
• Effectiveness of the Channel breakout 20-20 Trading System on 10
  Limit-Down Stocks in 2005
• Conclusion: C.B.O. 20-20 Trading System Was Effective

CHAPTER 9: Trading Bubble Stocks: The F-1 Trader Rule

• Introduction
• Discovery of the “F-1” Trader Rule
• Formula of the F-1 Trader Rule
• Screening is Required for the F-1 Trader Rule
• Effectiveness of the F-1 Trader Rule for Fast-moving Bubble Stocks
• Behavioural Finance
• Examples of Four Bubble Stocks
• Conclusion

APPENDICES

TABLES

DIAGRAM