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Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals by David R. Aronson

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CHAPTER 1

Objective Rules and Their Evaluation

This chapter introduces the notion of objective binary signaling rules and a methodology for their rigorous evaluation. It defines an evaluation benchmark based on the profitability of a noninformative signal. It also establishes the need to detrend market data so that the performances of rules with different long/short position biases can be compared.

THE GREAT DIVIDE: OBJECTIVE VERSUS SUBJECTIVE TECHNICAL ANALYSIS

Technical analysis (TA) divides into two broad categories: objective and subjective. Subjective TA is comprised of analysis methods and patterns that are not precisely defined. As a consequence, a conclusion derived from a subjective method reflects the private interpretations of the analyst applying the method. This creates the possibility that two analysts applying the same method to the same set of market data may arrive at entirely different conclusions. Therefore, subjective methods are untestable, and claims that they are effective are exempt from empirical challenge. This is fertile ground for myths to flourish.

In contrast, objective methods are clearly defined. When an objective analysis method is applied to market data, its signals or predictions are unambiguous. This makes it possible to simulate the method on historical data and determine its precise level of performance. This is called back testing. The back testing of an objective method is, therefore, a repeatable experiment which allows claims of profitability ...

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