Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

TYPES OF TECHNICAL INDICATORS: TREND-FOLLOWING AND MEAN REVERSION

Another common argument against technical analysis suggests price activity in commodity and financial markets is random.¹² In fact, instead of a random, bell-curved price distribution, most—around 70 percent—of the time, prices trade in a sideways or range-bound pattern.¹³ In statistical terms, commodity and financial markets are said to be leptokurtic. That is, they display a strong tendency toward mean reversion—in other words, prices tend to cluster around the mean.

Why then are such a large portion of technical analysts and mechanical trading systems dedicated to trend identification? The reason is because when prices are not in this mean reversion mode, they tend to trend. In statistical terms, commodity and financial markets are leptokurtic with amplified tails—when they are not in their mean-reverting mode, they tend to display powerful and sustainable trends. These trends offer traders low-risk/ high-reward opportunities, such that a single profitable trend-following trade often will offset numerous small losses, thereby resulting in an overall profitable trading system that experiences less than 50 percent winning trades.

The 200-day simple moving average examined earlier provides us with an excellent example of a trend-following indicator. Another popular variation on this mathematical trend-following indicator is known as the two-moving average crossover system (see Figure 1.4).

The two-moving-average ...