Probably the first contact with the financial market of most Brazilian investors was through technical analysis. I started there myself. Introductory stock exchange courses with emphasis on graphical analysis are the most abundant in the market as well as books and discussion forums on the subject. In Youtube, it is enough to search by the name of some technical indicator that will appear diverse tutorials explaining how to use it, as well as the parameters in which one must calibrate it to obtain the greater profitability. In addition, practical examples are always presented where such an indicator seems to perfectly predict the future.
But how could we not be impressed by the idea that it would be possible to master a technique that would indicate the points of entry and exit of operations in the financial market? And what, in addition, would it be possible to program algorithms that operate autonomously, looking for investment opportunities the whole time, without being subject to discretionary analysis or emotions?
The idea behind this series of articles will be to present a set of arguments that makes me to believe that the use of technical analysis to operate stocks in the intraday time frame does not make sense. Note that I will try to refute its applicability only for day-trade operations.
In lower frequency strategies, technical analysis may have good applicability. Trend Following models are the prime examples of this. Its input signals can be derived from the crossing between simple moving averages, Channel Breakouts, the analysis of the Hurst exponent of the time series studied, among others. It is important to emphasize that for such strategies, the input signal is NOT the most important parameter. The position sizing models used as well as the correct dimensioning of the stop-losses are by far much more important for the long-term survival of the stategy. I will not delve further into this topic because we intend to write a series of articles specifically on trend-following, besides presenting a complete model that we use applied to actions, with backtests and tests of sensitivity of the parameters.
But then why technical analysis as input signal in intraday frequency does not make sense?
To answer this question, I will divide the explanation into two topics:
What characteristics would the market need to have to make price-based strategies profitable?
Who are the players that are active in the intraday stock market and what variables are relevant to their decision-making?
Characteristics needed by the market
There are hundreds of technical indicators. Each indicator is calculated as a function of price and some other variables (in general, some lag). If we consider that each combination of indicator and parameter brings us some different information (from the point of view of technical analysis), the combination between them is capable of generating infinite new indicators. We can characterize these indicators in three categories: momentum, trend and volatility indicators.
Moment Indicators: Williams, Stochastic, IFR, SAR, Hilo Activator, etc.
Trend Indicators: MACD, Moving Averages, ADX, etc
Volatility Indicators: Average True Range (ATR), Bollinger Bands, Price Channels, etc.
Some of these indicators can be very useful in some aspects of automated systems. ATR, for example, is widely used to scale stops in low frequency systems. The point is that when we refer to input signals in operations, all indicators have one thing in common: they are derived from past quotes.
In this way, systems that use such indicators are essentially operating the idea that price predicts price. Such a concept would be true if the major market players, for the most part, used past prices as an important variable in their decision-making. And when I talk about the main agents, I mean the players who can move the price. Thus, it is necessary to analyze who these investors would be, and what variables are relevant to each one of them.
Stock market agents and their methods of decision-making
The stock market (just like any other) is made up of thousands of different investors. Everyone believes they are doing the right trade at a fair price. And they might be. Both buyer and seller. What obviously differs them are their decision-making logics, as well as the time horizon sought by the operation. Simply put, we can classify agents into:
- Long-term investors, who set up their operations without necessarily having a defined term, or with terms longer than 6 months. Small and medium-sized investors following Buy & Hold strategies, long-only investment funds, active or passive management, as well as foreign and native trading funds operating in a fundamentalist manner will generally fall into this category.
- Medium and short-term investors. Their operations can last from days to months. Agents seeking to make profits through arbitrage operations between assets (which may be based on the rationale or statistical relationships of the price series of the assets), investors seeking profit through operations to benefit from some insider or speculative information may fall here.
- High-frequency investors, who end up being the largest providers of liquidity in any market. It is the existence of such agents that provides the large investors with the necessary conditions for them to provide relevant resources in a given market. Without the liquidity provided by them, the market would lose some of its efficiency and probably the underlying country’s economy would be impaired (but that is a subject for another article). Among them, we can mention investors performing day-traders based on quantitative models of any nature, agents with access to reduced costs profiting from market making operations, arbitrators between stocks and: other stocks, commodities, ETFs, ADRs, but mainly arbiters Between the future IBOV index and the Bovespa index. The latter, in my opinion, is the main agent of stock prices movements in the intraday time frame and I intend to dedicate the second part of this article entirely to justify this point.
As we know, prices move through imbalances between supply and demand. Investors intent on buying / selling assets, but not in a hurry, record their intentions in the bid book, increasing the availability of assets in bid / ask, hoping that tougher investors will pay the spread and take them to market. If in a certain time window more investors propose to take more to the market at ask, for example, the price goes up. If they hit the bid more, the price drops.
For technical (or even quantitative) strategies to achieve alpha, it is necessary to find some pattern in the market that precedes a buyer / seller flow of most other market agents (or some large investor) in order for them to move the price.
If we are operating some Bollinger-Bands mean reverting strategy or some trend-following strategy based on ADX, we need other more relevant players to do the same after we get into the transaction. If this does not happen (and I seriously believe that it does not happen, given the number of concurrent and uncorrected investors in action), the movement that will follow such technical indications will be due only to the vectorial sum between the forces acting on the offer book at that moment.
And, as mentioned before, there is a group of investors that is present during all the course of the trading session: the arbitrators. However, I will dedicate the whole 2 part of this article trying to explain the performance of these players, as well as their influence on stock prices.
Questions, suggestions or rewies? Make contact. I’ll always be open to good discussion.