Mechanical trading systems can be defined as methods of generating trading signals and quantifying risk that are independent of an individual trader’s discretion. Although the advantages in utilizing a mechanical trading system are manifold, almost market participants agree that their greatest benefit is the tempering of destructive trader “emotionalism”—which is considered to be the enemy of all successful market participants—from the decision-making process.
Technical analysis can be used to develop two different types of mechanical trading systems: price-driven systems or indicator-driven systems (along with a combination of the two). Both types of trigger events can be used to produce successful trading systems because they capitalize on recurring psychological conditions in the market.
Successful trading can be considered as the systematic “fading” (buying whenever the indicator would sell and vice versa) of unsuccessful traders.
Price-driven systems generate signals based on support & resistance. Indicators are mathematically calculated values that determine either the trend, or the unsustainable nature of the current move. Indicators that determine the rend are called trend following indicators, while those hat determine the unsustainable nature of the current move are called Oscillators, or mean reversion indicators. An indicator-driven trigger is an occurrence such as a price close above or below a moving average or the crossing of an oscillator above or below a significant level.
Trend-Following Indicators: Why They Work
If we assume that the majority of market participants lack the psychological fortitude to allow profits to run and take losses quickly, then successful traders use trend- following indicators that necessarily reinforce their ability to actualize disciplined profit and loss goals. As a result, such trend-following technicians often find themselves on opposite sides of the market from their less successful counterparts. Contrary opinion is often the epitome of trend trading.
Mean Reversion Indicators: Why They Work
If trend following is such a successful methodology, how can indicators based on the exact opposite philosophy generate consistent profits? The simple answer is that mean reversion indicators, such as RSI and other oscillators, work because they capitalize on the market’s tendency to overextend itself.
Whether the trend has matured and is approaching climactic reversal or is still in its infancy and simply correcting a temporarily overbought or oversold condition, the market has an uncanny knack for separating the less experienced from their money by exploiting their greed, lack of patience, and complacency. Mean reversion indicators such as oscillators attempt to somehow quantify these unsustainable levels of market emotionalism.
PSYCHOLOGICAL PROFILE OF A TREND-FOLLOWING TRADER
Willingness to buy recent highs/sell recent lows. Unless traders adhere to this first premise, there is no point in reading on. Trend trading works because it is extremely difficult to buy highs and sell lows.
Willingness to exhibit patience through numerous, consecutive small losses.
Ability to be comfortable with 1 to 5 percent of trades executed generating most profits.
PSYCHOLOGICAL PROFILE OF A MEAN REVERSION TRADER
Gain the Discipline to Fade the Crowd. Without the discipline (and courage) to fade recent price action, we will forever remain paralyzed with fear, unable to initiate the trades generated by our systems.
Gain and Maintain the Discipline to Exit with Losses. It is extremely satisfying to buy low and sell high, and we all like to be right more often than we are wrong. Yet without the discipline to exit with losses when dictated by our system, one bad trade will end our career as a speculator
