Price Trends and Patterns in Technical Analysis: A Theoretical and Empirical Examination
47 Pages Posted: 20 Mar 2007
Date Written: August 2007
We develop a formal model of asset prices in which investors are subject to confirmation bias, which describes the tendency of individuals to search for and interpret information selectively to conform to a given set of beliefs. The model produces three notable results. First, the model generates price patterns which validate certain well-documented trading strategies, in particular the "head-and-shoulders" pattern. Second, asset prices exhibit negative autocorrelations over very short horizons, positive autocorrelations over intermediate horizons, and negative autocorrelations over long horizons, which matches the observed stylized properties of U.S. equity prices. Third, the model predicts that sequential price jumps for a particular stock will be positively autocorrelated. Several recent econometric papers have shown that one can identify significant jumps by comparing realized volatility and bi-power return variation. Using this methodology, together with tick-by-tick data on all stocks in the S&P 100 index from 1999-2005, we identify and calculate significant jumps in stock prices. Consistent with the predictions of the model, we find that jumps exhibit statistically and economically significant positive autocorrelations.
Keywords: Technical Analysis, Trading Rules, Equity Jumps, Momentum, Confirmatory Bias
JEL Classification: G14, G11, G1
Suggested Citation: Suggested Citation