Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

TECHNICAL ANALYSIS: WHY IT WORKS

As shown in later chapters, technical analysis can be used to develop two different types of mechanical trading systems: price-driven systems or indicator-driven systems (along with a combination of the two). Both types of trigger events can be used to produce successful trading systems because they capitalize on recurring psychological conditions in the market.

Psychological Significance of Price Triggers: Horizontal Support and Resistance Levels

To understand why technical analysis works in terms of market psychology, let us examine the heating oil futures market, which began trading on Nymex during the late 1970s.

The late 1970s and early 1980s marked a strong uptrend in energy prices. During the summer of 1979, heating oil futures tested the $1.05 per gallon region and then quickly returned to around $0.72/gallon. This failure to rise above $1.05/gallon defined that area as resistance, or the level at which the upward price momentum was thwarted.

Over the next few years, the market would again test the $1.05/gallon resistance level and again that price level would act as a ceiling, preventing penetration to higher price levels. In fact, the $1.05 level would be retested in 1981, 1982, and 1984 without being breached (see Figure 1.2).

In terms of market psychology, the $1.05/gallon level emerged as an important resistance mark and price trigger. Consider the significance of the $1.05 price level to various market participants. First we examine ...