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Technical Analysis and Liquidity: the Case of the Budapest Stock Exchange

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Technical Analysis and Liquidity: the Case of the Budapest Stock Exchange TECHNICAL ANALYSIS AND LIQUIDITY: THE CASE OF THE BUDAPEST STOCK EXCHANGE By Adam Farago Submitted to Central European University Department of Economics In partial fulfilment of the requirements for the degree of Master of Arts Supervisor: Professor Peter Kondor CEU eTD Collection Budapest, Hungary 2009 Abstract Technical analysis is a popular technique among financial practitioners for supporting their investment decisions. In this thesis I examine two aspects of technical analysis using data for 26 stocks of the Budapest Stock Exchange from the period between 1997 and 2008. First, I analyze the profitability of moving average indicators with the methodology developed by Brock et al. (1992). My results suggest that for the majority of the stocks, technical trading rules can be useful in predicting future price movements. In the second part of the thesis I study the relationship between market liquidity and the timing of signals generated by the most successful trading rules. Using panel data methods I find that there is no strong link between liquidity and the timing of signals. CEU eTD Collection i Table of Contents Abstract ....................................................................................................................................... i 1 Introduction ........................................................................................................................... 1 2 Data description ..................................................................................................................... 3 3 The performance of technical analysis .................................................................................. 5 3.1 Methodology ................................................................................................................... 9 3.2 Results .......................................................................................................................... 13 4 Liquidity on the Budapest Stock Exchange ......................................................................... 17 4.1 Methodology ................................................................................................................. 19 4.2 Results .......................................................................................................................... 21 5 Relationship between technical analysis and liquidity ........................................................ 24 5.1 Data and methodology .................................................................................................. 25 5.2 Results .......................................................................................................................... 28 6 Conclusion ........................................................................................................................... 30 Appendices ............................................................................................................................... 32 Appendix 1 Listing requirements for equities in category “A” .......................................... 32 Appendix 2 Moving average rules examined during the analysis ...................................... 33 Appendix 3 Figures ............................................................................................................ 34 Appendix 4 Tables .............................................................................................................. 35 Bibliography ............................................................................................................................. 43 CEU eTD Collection ii 1 Introduction Technical analysis is a common term for a wide range of methods trying to predict future price-movements of financial assets using past information, usually the time series of past prices of the assets. Technical analysis has been very popular among financial practitioners as a tool for supporting their investment decisions. Numerous survey studies have shown that this form of investment analysis is widely used in various futures markets (Brorsen & Irwin, 1987), foreign exchange markets (Gehrig & Menkhoff, 2006), and stock markets (Sehgal & Gupta, 2005) around the world. Despite the general acceptance of technical analysis among practitioners, academic research has been traditionally quite skeptical about it. According to Park and Irwin (2007), this skepticism was mainly due to two reasons. The first is the popularity of the efficient market hypothesis (Fama, 1970), which, even in its weakest form, implies that all the information carried by past price movements is already reflected in the current price, and thus cannot be used to achieve higher than average profits. The second reason for the original skepticism is the negative empirical findings in a number of early and widely cited studies about the profitability of technical analysis. In recent years, however, many studies have been published that seem to challenge the traditional opinion of academics. Some theoretical papers have shown that under certain circumstances technical analysis can provide valuable information (Treynor and Fergusson, 1985; Brown and Jennings 1989), and a great number of empirical studies have found technical analysis to be profitable on different markets over CEU eTD Collection different time periods (e.g. Brock et al., 1992; Bessembinder & Chan, 1998). Although substantial amount of literature is dealing with the profitability of technical techniques, so far no attempt has been made to analyze the relationship between liquidity and technical trading. Taking liquidity into account is really important when analyzing the 1 performance of technical analysis. The result of technical analysis is always a trading strategy that provides buying and selling signals. The implementation of this strategy involves active trading on the market. Therefore, transaction costs have a substantial effect on the profitability of the trading strategy. Some studies have dealt with this issue by assuming a fixed amount of transaction costs throughout the period analyzed. However, the problem with this approach is that the liquidity of the market is not constant over time. If there is a significant relationship between liquidity of the market and the timing of the trades required by the technical trading strategy, it has severe implications regarding profitability. If, for example, the technical trading rules generate trading signals more often in times of low liquidity, than the profit opportunity suggested by previous empirical studies cannot be exploited. As soon as someone tries to implement the trading strategy, the prices start to move against him quickly (because of the low liquidity), and the profit opportunity disappears. In this thesis I will analyze the link between liquidity and the performance of technical analysis. In order to analyze this relationship, I will use data from the Hungarian stock market, the Budapest Stock Exchange (BSE) from the period between 1997 and 2008. At the beginning of the analysis, two separate tasks have to be accomplished. After describing the data in chapter 2, I will start with examining the performance of technical analysis on the BSE over the sample period. I will evaluate the performance of certain moving average indicators using the methodology proposed by Brock et al. (1992). The assessment of the performance of technical analysis can be found in chapter 3. The second task is to measure the liquidity of assets traded on the BSE. In order to analyze how liquidity changed on the BSE over the CEU eTD Collection sample period, I will calculate two liquidity measures proposed in previous empirical studies. The methodology and results of liquidity measurement are presented in chapter 4. After completing these two separate tasks, I will analyze the link between liquidity and technical analysis in chapter 5. Chapter 6 concludes the results of the research. 2 2 Data description The empirical analysis of the thesis focuses on the Hungarian stock market, the Budapest Stock Exchange. I have chosen the period from July 1997 to December 2008 to study the relationship between technical analysis and liquidity. The start of the sample period was chosen to be this point, because of data availability. The BSE reports daily trading data in a well structured form for all the stocks listed, starting from July 1997. When selecting stocks into the sample, I was focusing on papers listed in Category “A” on the BSE. The shares in Category “A” are more liquid in general and have a broader ownership structure than shares listed in Category “B”. The reason for analyzing only relatively more liquid stocks is that technical analysis usually involves regular trading on the market. Thus, certain liquidity of a given stock is needed so that technical trading strategies can be implemented at all. In the case of Category “B” stocks, there are a lot of trading days without a single trade, and therefore testing how technical trading rules would perform is pointless for these shares. To be listed in category “A”, the company has to meet certain criteria set by the stock exchange regarding capitalization of the stock, the ownership structure and corporate history of the company. As of May 2009, the listing requirements for stocks in category “A” can be seen in Appendix 1. In the first step of building the database for the analysis, I collected which stocks were listed in Category “A” for every month of the sample period. At this point the sample contained 38
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