Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

MECHANICAL TRADING SYSTEMS: A DEFINITION

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, most 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.

Obviously mechanical trading systems can be developed based on any number of objective criteria including interest rate differentials, gross domestic product, or earnings per share. Although this book in no way negates the validity of such fundamental tools in system development,⁹ I do argue that an inherent limitation in using such tools is that they require an in-depth understanding of a particular market or trading instrument.

By contrast, mathematical technical indicators do not require any particular specialized knowledge of the underlying fundamentals affecting a particular market on the part of system developers. This absence of expertise thereby allows traders to apply their system as readily to Asian equities or live cattle, soybeans or foreign exchange, sugar or natural gas. Although obvious benefits gained by participating in diverse markets will be examined in detail later, for now let me suggest that diversification into various low to negatively correlated asset classes ...