To be a successful trader one should be part data scientist. Although there are some highly successful traders that hinge their plan on subjective analysis artforms, the road to long-term profits in active trading should be grounded in the laboratory of data. The simple reason for this: failure, as much as success, must be measured and understood because market outcomes are often inherently volatile and unpredictable. Scientific method allows us to test trading hypothesis, learn from mistakes, and quantify risk. Systematic traders understand that without the integrity of data science, they are simply ticker tape cowboys.
Having an analysis framework is an important departure point for the systematic investor. That framework could be fundamental / value analysis - translating measures of intrinsic value into trading signals. An example of this would be the Dogs of the Dow trading strategy. For market technicians core intrinsic value relationships are too complex to model completely. Instead, a technical analyst focuses on patterns of supply and demand for an investment instrument. Those patterns of subjective market valuations are revealed in the price and volume of every stock.
“It’s not good enough to be anecdotal or doctrinaire when it comes to trading.”
Market technicians believe in the market’s message. They construct price and volume charts to read the tea leaves, so to speak, about the future direction of a market price. But here’s where this backward-looking artform often fails: how can a technical analyst place any faith in the reading of these charts? It’s not good enough to be anecdotal or doctrinaire when it comes to trading. It’s not good enough to show a tidy chart that reveals, for example, a head and shoulders pattern, and assert a projection for future price movement if there is no data from which to develop a measure of confidence in the prognostication.
There should be some standard of evidence to support a particular chart reading. If there is no evidence, there’s no foundation for acceptance. A technical trader should quantify the probabilities of future outcomes. Data science allows the diligent systematic investor to develop a level of confidence in a market environment that is fundamentally uncertain. Risk must be quantified!
How does Stock Trends help us turn stock market data into actionable quantitative measures of confidence? First, the Stock Trends indicators are by definition categorical - they translate market price and volume data into factor variables, or independent variables. In a data science setting we can use these independent variables as inputs and measure a relevant outcome, or output. The significant outcome for investors, of course, is the future return. If a dependent relationship is established between the inputs and the output, the trader can measure a confidence level for a desired trading outcome. Let’s now look at each of the Stock Trends indicators and how they fit our Stock Trends Inference Model.
The Stock Trends trend categories are the result of a method of translating market price data (quantitative variables) into categorical variables. For instance, last week’s closing price of Apple (AAPL) was $126.60. The Stock Trends trend indicator categorizes that price by applying a framework for qualification and putting the current price into a long-term price context. Using 13-week and 40-week average prices as guideposts, the trend indicator - now Stock Trends Bullish () - gives us a factor variable for the $126.60 market price.
A base test, then, would be to measure how a market price performs when it is in this trend category. However, we would want a more granular categorization because within each trend category there are many ancillary variable qualifications. For instance, a Bullish trend category can be relatively new, or it can be quite entrenched.
That is why Stock Trends publishes trend counters. They give us a better understanding of the time frame of the trend category. In our Apple example we can see that the current Bullish trend category has been in place for 92-weeks, about twice the average length of a typical Bullish trend, and that the current strong Bullish indicator has been in place for 22-weeks. So now we can ask the following question: how have stocks performed when they have been in a Bullish trend category for about 92-weeks, and also in a strong Bullish indicator for the most recent 22-weeks?
But our granularity can be improved even more. We also recognize that within any trend there are varying levels of price momentum. Stocks rally and retreat. The Stock Trends Relative Strength Indicators provide us with a method for translating price performance into factor inputs. The 13-week RSI values are discrete variables that can be cut into bins of specific ranges of values. By qualifying each stock’s trend by its relative price momentum to the broad market we can now be more specific about the characteristics we are sampling. In the case of our Apple example, its 13-week RSI is 100. This indicates the stock is only performing at par with the S&P 500 over the past 13-weeks. Now we can sample for Bullish stocks that also share this condition.
The RSI +/- indicator is a binary signal of whether a stock has outperformed or underperformed the broad market in the past week. Again, this indicator can be used as another factor input. Apple underperformed the S&P 500 index last week, and therefore has a (-) indicator.
Finally, another factor variable that Stock Trends creates is derived from the weekly volume of shares traded. Three different factor levels characterize the weekly volume, so that we can differentiate stocks further by which level the trading volume fits. Last week Apple had neither high nor low volume of trading, so its volume can be characterised as normal.
With these composite factor variables, published in each Stock Trends Report, the Stock Trends Profile presents the results of the Stock Trends Inference Model. In the case of Apple, shown below, we can see that the current Stock Trends indicators are relatively positive: the future 4-week return of Apple has a 57% probability being higher than the expected mean random return of a stock, which is 0%. Remember, that a randomly chosen stock has a 50% chance of having a 4-week return greater than 0% (see The random outcome benchmark). AAPL has a 62.2% chance of besting the base mean 13-week random return, which is 2.19%, and a 56% probability of besting the mean 40-week random return (6.45%) .
These probabilities might not strike you as significantly positive. However, they do indicate that the trend and momentum conditions for AAPL are sufficiently supportive of a continued bullish stance for Apple investors. The analysis also tells us that AAPL is more appealing than stocks with lower return expectations. You can compare the returns expectations of industry stocks in the associated heatmap that ranks the expected future returns.
This is the analysis framework of Stock Trends: translating the weekly trading statistics of an issue into factor input variables. It is how we interpret these variables and their significance in predicting future price performance that makes Stock Trends a unique and effective data science application. The Stock Trends Inference Model statistically measures the change in stock price that follows from each market condition defined by the composite of the inputs of each Stock Trends indicator combination.
Stock Trends covers the North American stock market - thousands of issues every week are categorized by the Stock Trends indicators. Each of these observations since 1980 - now numbering over 9.2-million records - can be used as input variables in models that measure the subsequent price change in the categorized stock. We can ask the question: what kind of returns did a stock have after it was categorized by the Stock Trends indicators? Do stocks that have a Bullish trend indicator and high price momentum perform better, on average, than other stocks? Is there any statistical evidence that momentum trading is profitable? Does a Bullish Crossover offer a good trade entry signal? More broadly, does the data support many of the doctrinaire positions of technical analysis? The Stock Trends Inference Model attempts to answer these type of questions.
"Every technical analyst who presents a price chart as evidence of a buy signal must also present a distribution graph of the expected returns. If they don't, take their advice with a grain of salt."
Stock Trends analysis framework is simple, but specific. It looks at certain important aspects of technical analysis - trend and price momentum. Another analysis framework might be centered on other algorithms of price and volume, and on a different time frame. Every investor has to choose what analysis framework fits their own assumptions about the dependent relationships in the market. However, each analysis framework must be measureable. The litmus test of this measurement should be the the presentation of data, the display of returns distributions. Indeed, in my opinion every technical analyst who presents a price chart as evidence of a buy signal must also present a distribution graph of the expected returns. If they don’t, take their advice with a grain of salt. Your success as a systematic investor will reflect your diligence in making data science integral to your trading strategies.