Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

PRELIMINARY CONSIDERATIONS

Chapter 2 addressed the issue of how indicators could be turned into trading systems; it did not cover the process of system development and various considerations inherent in the backtesting of a trading strategy. Now that we are ready to analyze the success or failure of a particular trading system, we need to examine these issues.

Considerations with Any Indicator-Driven Triggers

Entry and exit levels are self-explanatory for price-driven triggers since the violation of a historical high or low signals entry or exit of a particular price-driven trading system, such as channel breakout. By contrast, indicator-driven triggers raise a myriad of entry and exit level questions for system developers. The first question is fairly subjective: Are we as traders able to watch the screen and place entry or exit orders as the indicator levels are violated intraday? If so, we run the risk of trading an intraday violation that could reverse itself and not trigger a signal at end of day. Of course, the advantage in taking an intraday signal is the potential for better prices (less risk and greater reward); however, most system developers prefer knowing that the signal will remain valid at end of day (since the results of all intermediate to long-term trading system are necessarily based on end-of-day signals only).

Because most system developers rely on end-of-day indicator-driven entry and exit triggers, the next question is: Do we assume our entry/exit price level ...