Trading Rules

Abstract

Trading rules are devices used by traders in financial markets to obtain buy and sell signals according to some predetermined criteria. Although trading rules are normally associated with technical analysis, it is possible to devise some rules that are based on fundamental analysis, that is on economic models. Hence, we may distinguish between technical rules and fundamental rules. In technical rules a buy signal is indicated if it is established that an upward trend will continue, and a sell signal is indicated if a downward trend is perceived to continue for some time in the future. If the trading rule is based on the concept of an equilibrium exchange rate then a currency is bought when it is undervalued (the exchange rate is below the equilibrium level) and sold when it is overvalued (above the equilibrium level). In fundamental rules the buy and sell signals are extracted from the behaviour of the underlying trend of the exchange rate series or they are indicated by deviations from an equilibrium or a ‘fair value’ of the exchange rate. Thus, trading rules based on technical analysis and fundamental analysis may lead to contrasting decisions as we will see later. The objective of this chapter is to describe the basic technical trading rules as well as their modifications, and to present the empirical evidence on the profitability or otherwise of trading strategies based on these rules. We will also describe some fundamental trading rules and compare them with the technical rules. We start with a description of the first type of technical trading rules: filter rules.