Popularity versus profitability
May 2, 2017
Financial markets are notoriously difficult to predict. However, that has not stopped many investors from trying to find prediction rules that might work. Academic researchers now accept that in some cases markets can be forecasted by following certain rules.
The focus in academic research is no longer on whether financial markets can be forecasted but how markets can best be predicted and what happens to rules that work. Will their profitability remain? Or, if more and more investors start using these rules, will the profitability from these rules disappear? In their study: 'Popularity versus Profitability: Evidence from Bollinger Bands' that will be published in the Journal of Portfolio Management later this year, Ben Jacobsen jointly with Jasmine Fang and Yafeng Qiu study what happens to one such rule: Forecast generated by a technical analysis strategy known as ‘Bollinger bands’.
Technical analysis is a technique where investors search for historical patterns in prices to predict future price movements. Despite the ongoing debate in the academic literature on its profitability, technical analysis remains popular. Techniques involving Bollinger Bands are some of the most widely used. Bollinger Bands generate trading signals when recent prices have moved up too high or too relative to the normal price ranges for a certain stock or market.
John Bollinger introduced Bollinger Bands in 1983 on the Financial News Network (which eventually became CNBC), where he was chief market analyst. Ever since, Bollinger Bands gradually gained popularity among investors. In 2001, Bollinger published his book on this indicator, Bollinger on Bollinger Bands. In four years’ time, the English version of the book witnessed seven editions and the book has to date been translated into twelve languages. Recent survey results suggest Bollinger Bands have become a technical analyst favorite.
Interesting natural experiment
Did this increasing popularity affect the potential profits of Bollinger Bands-based trading strategies? Bollinger Bands are an interesting natural experiment to verify whether and how the popularity of trading strategies affects their profitability. First, unlike other popular technical analysis strategies, this trading strategy was not known before 1983. Second, Bollinger bands are easy to construct and implement because they use only information derived from historical prices. Third, we have a reasonable indication of the increasing popularity over time and large enough data samples to measure profits in different time periods. Fourth, Bollinger Bands originated in the US market and also Bollinger on Bollinger Bands was first published there. So if profits are arbitraged away we would expect the impact to show up in the United States. Fifth, it might explain why the profitability Bollinger bands in other studies that rely on different sample periods and countries is mixed. And, last but not least - given their popularity among investors - it is interesting to see how the profitability of Bollinger Band strategies have developed over time.
The results of this new study by Fang, Jacobsen and Qiu indicates that potentially profitable trading strategies self-destruct with increasing popularity. They find that Bollinger Bands generate significant outperformance in all fourteen major international market indices when measured over the full sample period. Before the introduction of Bollinger bands in 1983 the profitability is strong with high average returns in all countries. However, in the next sub-sample, from 1983 until 2001 when Bollinger’s book was published the profitability of Bollinger Bands decreases with around 50% on average in all markets. In the US, there is no longer outperformance. After publication the profitability of Bollinger Bands further shrinks with an average decline of 156% for all countries.
While it is often assumed that trading will make the profits of anomalies disappear, only few studies have tried to see whether and when this happens. The results of this study suggest that investor trading can indeed destroy such profitability over time.
The study Popularity versus Profitability: Evidence from Bollinger Bands
by Jiali Fang, Ben Jacobsen and Yafeng Qin will appear in the second half of 2017 in the Journal of Portfolio Management. An early version of the paper can be downloaded here.
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