Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

TYPES OF TECHNICAL INDICATORS

As stated in Chapter 1, there are two categories of mathematical technical indicators, those traditionally used to capitalize on the market's propensity toward mean reversion such as oscillators, and those that profit from trending price activity, such as moving averages. Although many books on technical analysis treat these various indicators as if they worked exclusively in either trend-following or mean-reverting trading environments, this book will show how indicators can be successfully applied to either realm.

Trend-Following Indicators: Why They Work

I have already highlighted some of the psychology behind the success of trend-following indicators in the discussion of reference points in behavioral finance. In Chapter 1, I showed how emphasis on reference price points led traders to take small profits and large losses. 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. This theme of successful trading as the systematic “fading” (buying whenever the indicator would sell and vice versa) of unsuccessful traders will be revisited throughout the text.

Because successful trend-following ...