Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

DISPELLING THE MYTHS: THE INEFFICIENT MARKET AND THE HARD ROAD TO PROFITS

The Inefficient Market

If traders behaved in a rational manner, the market would be efficient and trading would offer few opportunities for consistent profit, but time and again market participants behave illogically, basing their decisions on emotional responses. Perhaps the most compelling evidence in terms of market participant irrationality is put forth by proponents of behavioral finance. Behavioral finance, when traders or investors base decisions on emotions, is diametrically opposed to theories of random market behavior and efficient market hypothesis, which assumes that all market participants behave rationally.¹

Recent acceptance of behavioral finance by the academic community² validates what technicians have known for well over 100 years: Market participants behave irrationally, and it is this emotionalism that leads to stable Paretian price distributions.³ Such distributions are characterized by a greater propensity toward mean reversion than suggested by a random distribution, which technicians capitalize on with mean reversion tools, such as Wilder's Relative Strength Index, and amplified tails—also known as trends—which technicians profit from through trend-following tools, such as moving averages.⁴

Although the irrationality of markets is why technical analysis works, it is also the greatest danger in the execution of a mechanical trading system. Traders must have the discipline to continuously ...