Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

TREND-FOLLOWING MEAN REVERSION SYSTEMS

Some trading systems can easily be tailored to capitalize on reversion to the mean while still trading in the direction of the long-term trend. Although they are not without drawbacks, these systems are often easier for new traders to stick with—assuming they have already mastered the discipline required to fade mass psychology—because they enter at recent market extremes (selling recent highs or buying recent lows), while simultaneously trading in the direction of the longer-term trend (which results in greater confidence during drawdowns).

In addition, because these are mean reversion systems, traders exit with profits once the market reverts back to the average. Because both risk and reward are quantified at the time of the trade's initiation, one of the most difficult psychological obstacles to successful trend trading—letting profits run—has been eliminated.

Relative Strength Index Extremes with 200-Day Moving Average Filter

This system waits for the market to achieve extreme overbought or oversold relative strength index (RSI) levels while still trading in the direction of the long-term trend through its use of a 200-day moving average as a filter. Because we are trading the direction of the long-term trend, we can place our exit with profit criteria levels somewhere beyond the mean. In this case we exit long positions when the 14-day RSI crosses beyond the 60 level and exit shorts when the 40 level is breached.

As discussed in Chapter ...