Testing Momentum Indicators with Trading Rules and Statistical Evidence
Summary
The document discusses how to assess whether momentum indicators such as RSI or TRIX have predictive value. Its practical recommendation is to evaluate an indicator as part of a complete trading strategy: specify entry and exit rules, backtest the resulting positions, and include transaction costs. Correlation or directional accuracy alone can be misleading because prediction errors may have disproportionate effects on trading capital.
For academic analysis, the responses point to evidence-based technical analysis and prior research on momentum strategies and technical indicators. They name foundational momentum studies and research examining popular indicators, but provide no study results, datasets, or statistical procedures in detail. The discussion is therefore a starting point for further reading, not proof that any particular indicator works. Backtest conclusions depend on the rules, costs, data, and research design used.
Key ideas
- Test an indicator through explicit entry and exit rules that can be evaluated as a strategy.
- Include transaction costs when estimating whether a signal could produce useful trading results.
- Correlation and directional accuracy alone do not establish that a signal is profitable.
- Evidence-based technical analysis and published momentum studies are suggested as research starting points.
- The document gives references but no specific results or testing protocol.
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Full text
# How can I quantitatively test the validity of momentum indicators? # How can I quantitatively test the validity of momentum indicators? I am learning about quantitative finance, and I am struck by how different it is from the techniques that make it into magazines and TV, particularly technical analysis. Specifically, if they say an indicator (RSI, TRIX, etc.) can predict even short term future prices, then you should be able to run some analysis to see if this was at least true in the past. So my questions are: If I wanted to learn the statistics used to calculate if there is any correlation between an indicator and any future price tendencies, what methods do I use? Are any of these indicators known to have been verified quantitatively? ## Answer by Zarbouzou (score 7, accepted) https://quant.stackexchange.com/a/1333 Remember that there is almost no point in predicting market movements if you cannot use it to trade and generate P&L. Thus, backtesting a stat arb strategy based on the indicator is best option. Don't let yourself fooled by correlation or even directional forecast percentage accuracy as a few wrong predictions can blow your capital. - You will need a set of entry and exit rules in addition to your indicator. (enter when indicator 1 is crosses 0.5 from below etc) - Don't forget to account for all types of transaction fees you will have to pay. If it's purely academic research you are doing then what I just said is of course not true. ## Answer by Louis Marascio (score 5) https://quant.stackexchange.com/a/1872 You might want to check out the book Evidence Based Technical Analysis by David Aronson. In it he applies statistical techniques to determine whether certain technical analysis indicators and ensembles have any predictive power. It's an interesting read and should equip you with some ideas on how you might perform a similar analysis. ## Answer by Tal Fishman (score 5) https://quant.stackexchange.com/a/1875 There is so much finance literature on this topic, I don't even know where to begin. Specifically on momentum, some of the earlier foundational papers are - Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency - Momentum Strategies - Price Momentum and Trading Volume - International Momentum Strategies Momentum has an entire page devoted to it at behaviouralfinance.net. Lo, Mamaysky, and Wang (2000) conduct rigorous tests of a variety of popular technical indicators (although not specifically the ones you mention). ## Answer by NN1983 (score 3) https://quant.stackexchange.com/a/7078 Cliff Asness's PhD thesis was based on Momentum and Value. AQR has a lot of interesting research. http://www.aqrindex.com/AQR_Momentum_Indices/Momentum_Research/Content/default.fs http://aqr.com/Research/ByTopic.aspx Jegadeesh and Titman (Returns to Buying Winners...- first paper linked in the above answer ) seems to be the standard reference. ## Answer by vonjd (score 3) https://quant.stackexchange.com/a/7079 Renowned CXO Advisory Group have created a research compendium exclusively on momentum investing. This is the most exhaustive treatment of the topic I have ever seen: The Momentum Investing Research Compendium With $25 the price is reasonable.
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