Technical analysis of selected chart patterns and the impact of macroeconomic indicators in the decision-making process on the foreign exchange market

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1 Summary of the doctoral dissertation written under the guidance of prof. dr. hab. Włodzimierza Szkutnika Technical analysis of selected chart patterns and the impact of macroeconomic indicators in the decision-making process on the foreign exchange market D o m i n i k D r e s z e r The PhD dissertation undertakes problematic aspects of foreign exchange market. The subject of interest include selected formations of technical analysis and macroeconomic indicators in a context of short term fluctuations of the exchange rate. As a result of collapsing of the pegged exchange rate of US dollar to gold ounce in the beginning of the seventies of the 20th century, foreign exchange market has become the fastest growing financial market in the world. Today it is one of the elements of the global financial system and we find it difficult to imagine the modern world s economy function without it. In the initial phase of its existence foreign exchange operations were mostly conducted between central banks, international corporations and institutional investors. Along with the development of information technology (IT) individual investors, who had not been in the position to invest in currencies before, gained access to it. Consequently, the share of (short-term) profitmaking transactions rose causing more competition and the need to seek more investment strategies. An attempt to give market phenomena some measurable features, in order to minimize an element of randomness and uncertainty in the decision-making process, has led to developing many methods of examining economic markets that aim at measuring their fluctuations and analytical support. Two of the most popular investment techniques are technical analysis and fundamental analysis. The first one gives rise to controversy among the researchers, as its methods and results can be sometimes ambiguous. Despite a rich history, empirical testing has not given a clear, explicit answer so far when it comes to a prognostic value of technical analysis. Some of the tests prove the effectiveness of its tools, while others challenge their practical use. Nevertheless, this method is used by practitioners in the field of financial markets and institutional investors who usually have a better access to information and a constant insight into order books.

2 One of the tools used to forecast and determine the direction of the trend are Japanese candlestick charting techniques. Their indexes are a major indicator to many professional investors in a decision-making process, also among those in Poland, which allows us to think there is a connection between the indexes and currency exchange rates 1. Even though the Japanese candlestick method is very popular, unfortunately, none of publications in economics offer an objective answer to a question about its usefulness in currency investment transactions. Most of the academic research conducted are based on the stock market (mostly American, Japanese, Taiwanese and Chinese) which significantly differs from foreign exchange market. It is also necessary to stress that some publications are questionable due to their methodological weaknesses 2. Filling this gap was the main motive and inspiration behind this thesis. A fundamental aim of this paper is to provide a relation between indications of the technical analysis based on the Japanese investment techniques and rates of major currency exchange pairs. The choice of the Japanese techniques of analyzing charts was dictated by the fact that it is a dominant method of construction and analysis of the price of various financial instruments, including currencies. Moreover, some specific objectives are discussed in this paper along with the fundament aim mentioned above, which include: 1. Systematizing knowledge of the global currency market and a quantitative analysis of liquidity and structure in a daily currencies turnover. 2. Identifying a mechanism responsible for currency exchange rates and introducing rules and regulations of making transactions. 3. Diagnosing modern economy as a competition area in terms of speculative currency attacks. 4. Demonstrating the rightness of use of the classical technical analysis and areas of advantage in the forecast of future price changes of financial instruments. 5. Studying the relation between indicators of the technical analysis and a reaction of exchange rates in a short period of time. 1 This method is used by fund managers to forecast short-term trends and market turning points. L. Menkhoff: The use of technical analysis by fund managers: International evidence. Journal of Banking & Finance, 34 (2010), pp G. L. Morris research related to American market are only based on a simple analysis of frequencies of individual Japanese candlestick formations. Y.J. Goo, D.H. Chen & Y.W. Chang examine profitability of the method when implementing stop-loss orders. However, they do not include those transactions in the consecutive periods to an average return rate. Consequently, their results are inflated and impossible to achieve in reality. 2

3 6. Assessing prediction abilities and profitability of individual formations and how it affects the observed exchange rate changes. 7. Drawing attention to dangers of investing in Forex and establishing methods of avoiding the risk. Furthermore, technical aspects related to making transactions with the use of electronic platforms of exchange were inspected, which is a result of the lack of literature on the subject. As a consequence, there is no awareness of dangers that might be an obstacle when investing in the foreign exchange market. Private investors results are signifying here, as it proves that more interest towards the exchange market does not reflect in a measurable increase in social awareness about the matter 3. Based on analysis of published theoretical papers and the author s own experience on functioning of the foreign exchange market the following research hypotheses were formed: 1. The evolution of the foreign exchange market determined by the breakdown of the Bretton Woods system, globalization, de-regulation and new technologies that also helped to establish an electronic exchange platform. 2. Forex is a competition area which, under certain circumstances, might become a threat to global economy. 3. Technical analysis as a method of forecasting future price movements eliminates discrepancies between reality and expectation, exceeds an attitude that is strictly fundamental when elaborating on investment strategies. 4. Behavioral tendencies determine investors actions which do not meet the criteria of classical rational choice theory. 5. Indicators of candlestick formations signal a significant reaction of exchange rates, which help to forecast price trends and create investment strategies with a positive return. The paper is of a practical nature and its research profile is aimed at verification of established hypotheses, which is clearly shown by the structure of the thesis. Completion of the main purpose lets us create conditions for a short-term forecasting exchange rate fluctuations and, potentially, long-term also. Plus, it contributes to the creation of a crucial element of information system for aiding the investment process. Defined purposes and research hypotheses are not only scientific and cognitive but can be put into practice. It is considered that 3 KNF s statement on the results of clients on the foreign exchange market in the years

4 private investors, fund managers and any entity making transactions on any form of financial market, where a positive return is possible, may have a particular interest in the work. Considering a complex process of currency rates fluctuations, various research methods were implemented in the paper. A critical analysis of foreign and domestic publications was used among other methods, which helped to identify a research gap and the purpose and theses of the work were specified. To verify the hypotheses the following methods were applied: the logical-analytic method, cause and effect analysis and statistical methods (i.e. data analysis and statistical conclusion techniques). Secondary sources showing results of research on operations on foreign currencies gathered by Bank for International Settlements (BIS) and primary sources involving historical data published by stooq.pl were also used in the dissertation. The study was aimed at the research innovation, but also the innovative way of testing so the results of research are of significant cognitive value, but also of practical relevance. The selection included 12 carefully chosen reversal patterns. These are both bullish patterns, signaling the end of a downtrend, as well as bearish patterns, signaling the end of an uptrend. The study period covers the years and includes the daily exchange rates of the main currency pairs inclusive of the US dollar. The choice of instruments is based on the assumption of the continued use of research results by individual investors. The basis for the results compilation were exit strategies defined by Marshall-Young-Rose and Caginalp-Laurent. Exchange rate reactions were studied at intervals of 1 to 10 days in terms of frequency, effectiveness and profitability. The obtained results were checked by selected statistical tests and then, based on those the scenario analysis of the transaction system was performed. The dissertation includes the introduction, five chapters and conclusions. In the introduction, the justification for the research problem was formulated, the purpose of the paper was stated, and research hypotheses were created. In the conclusion, the research results were summed up and the main purpose of the thesis was commented on again along with the research hypotheses. In chapter one, Determinants and the peculiarities of the foreign exchange market, the origin of the foreign exchange market, its position in modern finances, market participants and motives for foreign exchange trading are presented. The financial instruments are classified, and a quantitative analysis of the exchange is conducted. It also discusses factors that determine the dynamic development of the foreign exchange market, pointing at, inter alia, roles of globalization, technology and liquid exchange rates. The key role was attributed to technological changes, which led to significant transformations in the organization and form 4

5 of the market functioning. Changes in the entity structure, an increase in market transparency, a decrease in transaction costs, new models of service delivery and numerous financial innovations have been observed. The chapter provides fundamental arguments for the positive verification of the first research hypothesis. Chapter two, Foreign exchange risk in terms of investment activities, is devoted to foreign exchange risk with regard to economic and investment activities. It approximates tools used to prevent from exchange risk and gives a short description of the above. Factors influencing the direction of the exchange rates are identified, including aspects that determine a choice of exchange rate mechanism. From the point of view of the second partial objective and the verification of the second hypothesis, the essential part of the chapter is a discussion of the role of the exchange rate in shaping the competitiveness of economies and the analysis of results of reactions to financial markets and global economy. The arguments submitted show that the currency market is a space for competition and responses to it lead to international foreign exchange policy disputes, and, in the long run, to interest rates and fiscal policy debates. A detailed analysis of the problem shows that, in today s economy, some of the hallmarks of currency war occur. However, it should be emphasized that they have a rhetorical character and do not differ significantly from the events of previous periods. In the third chapter, Trading mechanism in the electronic foreign exchange market, the author outlines the rules for making transactions with the use of electronic platforms and identifies opportunities and dangers resulting from the use of financial leverage. It also discusses the notion of contract for difference, which is often ignored and excluded from financial market studies. On top of that, the chapter highlights the risks and implications of financial innovation, together with increasingly occurring high frequency trading (HFT), which is crucial for the realization of the last partial objective. The main currency pairs are reviewed, and the technical aspect of the investment process is explained. Chapter four, The role of technical analysis in the process of making investment decisions, deals with possibilities of forecasting exchange rates and makes an attempt to respond to allegations about the technical analysis. With regard to the Random Walk Theory it shows that the currency market does not fulfill all the assumptions of the efficient market - there is a strong asymmetry of information, activities of investors are unreasonable, in addition, there may be temporary liquidity problems. As a result, prices, instead of changing randomly, behave in an irrational, yet explicable way and sometimes foreseeable, which is the existence of technical analysis. Particular attention is paid to the behavioral aspects of the investment process 5

6 that often condition the rationality of decisions made. It is confirmed and supported by numerous examples that decisions of individuals do not meet the criteria of classical theory of rational choice. In fact, human beings are not homo oeconomicus, as they break the classic axioms of preference and are not able to discard emotions, especially in the face of risk or uncertainty. From the point of view of the main purpose of this thesis, an important part of the chapter is the theory of Japanese methods of analyzing charts with particular emphasis on selected candlestick formations. The content of the chapter contributes to the implementation of the fourth and fifth specific objectives of the study, as well as the third and fourth research hypotheses. In chapter five, Analysis of exchange rate changes in response to selected candlestick patterns, we read about test methods used in the empirical analysis, the results of the study are then presented, which allows a partial verification of the fifth research hypothesis. The analysis of the materials and analyses carried out shows that the method of Japanese candlesticks may be a valuable tool in foreign exchange investment. The empirical results confirm the effectiveness and profitability of two examined patterns, which means that these formations are effective on the market and can be a source of advantage in trading activities. Positive returns generated are strong arguments for using signals from the method of building an investment strategy, which was proved in the conducted scenario analysis. The results of the analysis of the effectiveness and profitability of the Japanese candlestick formations are converging with the works by G. Caginalp and H. Laurent, even though they apply to different markets 4. In addition, there is a relationship between the period considered and the effectiveness and profitability of the method. It has been observed that a trend change takes longer than it arises from the G.L. Morris studies 5. Best results were obtained in the last days of the research. Therefore, formations that improve efficiency and profitability over time should be subject to further observation. Studies have also shown that some patterns do not achieve statistically significant results, while others are simply ineffective in a trend forecast and/or unprofitable. This raises the meaning of the question of the existence of these formations and their role in the investment process in the foreign exchange market. Since the results achieved mostly oscillate around the expected values, the technical analysis should not be treated as the golden mean and a way of rapid earnings. 4 G. Caginalp, H. Laurent: The predictive power of price patterns. Applied Mathematical Finance, 5 (1998), pp G.L. Morris: Candlestick Charting Explained: Timeless Techniques for Trading Stocks and Futures. McGraw-Hill Education; 3 edition, 2006, pp

7 To sum up, the results of the study provide a new knowledge of the effectiveness and success of the individual shapes and formations in the assessment of exchange rate fluctuations and allow them to answer the question whether they are, in certain conditions and not only in exchange markets, statistically significant advantage in economically important investments, which results from investing in currency. The proposed study may be the starting point for further research on the use of technical analysis tools in foreign exchange investments, particularly in the area of potential efficiency and profitability. The occurrence of certain restrictions mentioned in the final chapter does not reduce the added value of the studies carried out, but only points to a number of challenges arising from the use of the method. However, the studies have a significant practical dimension as they provide a substantive support in forecasting price trends and it does not remain irrelevant for the investment performance achieved by funds managing asset portfolio where currencies are essential components. 7