Mechanical Trading Systems for Market & trend Analysis

Mechanical Trading Systems: Analyzing Markets and Trends with Precision

March 26, 2024

We’ve been led to believe that mastering mechanical systems and fundamental analysis is essential for achieving market success. However, let’s take a step back and consider that fundamental analysis is a hidden mechanical system. It presents standardized data, making it understandable for anyone with minimal effort. Similarly, automated trading systems offer a set of rules that, when followed, transform traders into robotic adherents of a routine.

Here enters the paradox theory, which posits that we often obtain the opposite of what we pursue. In the financial markets, it’s evident that the majority must lose for the big players to profit. This is why the 90/10 ratio remains relatively unchanged, with 90% representing the percentage of losers and 10% representing the percentage of winners.

Exploring why mechanical trading systems are destined to fail could delve into intricate details that might lull you to sleep. Let’s briefly focus on “mechanical” to keep things engaging. According to Merriam-Webster’s online dictionary, one definition of mechanical is “done as if by a machine: seemingly uninfluenced by the mind or emotions.

The Human Element: A Vital Factor Ignored by Mechanical Trading Systems

Relying solely on mechanical trading systems overlooks the critical role of human judgment, intuition, and emotional intelligence in successfully navigating the markets.

Notice that the keywords here are “uninfluenced by the mind or emotions.” First, the market is nothing but a composition of a million reasons. Therefore, utilizing a system based on the rules set forth by one person’s mind and, worse still, devoid of any mental influence is a recipe for disaster. Secondly, the marketplace is a swirling pool of emotions: lust, greed, power, hate, fear, etc., moving through the markets like a hurricane descending on a village of huts, ready to decimate everything in sight. The above definition of mechanical is enough to make you want to flee from any such system.

Mechanical Trading Systems’ Limits: Overlooking Human Mind and Emotions

Delving into why mechanical trading systems are bound to fail can become intricate and potentially dull. Let’s focus on the term “mechanical” to keep things engaging. According to Merriam-Webster’s online dictionary, one definition of mechanical is “done as if by a machine: seemingly uninfluenced by the mind or emotions.”

Consider the keywords “uninfluenced by the mind or emotions.” Firstly, the market consists of countless individuals with thoughts and emotions. Relying on a system created by a single individual’s mind, detached from any mental influence, can lead to disastrous outcomes. Secondly, the market is a whirlwind of emotions, including lust, greed, power, hate, and fear. These emotions permeate the market like a hurricane approaching a vulnerable village, ready to wreak havoc on everything in its path. The definition of “mechanical” alone is enough to make one want to steer clear of such systems.

It’s essential to recognize that the market is not solely driven by numbers and rules but also by the complex interplay of human psychology and emotions. Ignoring the power of human judgment, intuition, and emotional intelligence in navigating the markets successfully can be a significant oversight.

The Intriguing Language of the Markets: Analyzing the Psychological Impact

How we represent the market and our positions within it through language reveals underlying psychological tendencies. Terms like bullish and bearish, which express market optimism and pessimism, respectively, seem to involve choosing some of the most irrational and easily provoked animals. It’s almost as if we possess an unconscious desire to embrace a syndrome of programmed loss.

Moreover, when discussing specific sectors, we use terms like bugs, such as Internet bugs or gold bugs. Intriguingly, we associate ourselves with a creature as unpleasant as bugs to represent our positions and views. Most humans react negatively to bugs, often instinctively wanting to crush them.

Even the language used in market discussions reflects psychological nuances. Terms like scalp, plunge, upthrust, perfect bottom, down thrust, flip, and climactic sell-off carry emotional connotations and depict intense market movements. This highlights how our language is intertwined with the psychological impact of market experiences.

By recognizing the underlying psychological elements in the language of the markets, we can gain insight into the intricate dynamics at play. It reminds us to approach the markets with a level-headed mindset, considering the psychological biases and influences that can shape our decisions.

Repeating the Mistakes: A Cycle of Primitive Views and Grandiose Errors

The most unfortunate aspect is that we pass nothing new to the next generation. Instead, we reinforce these primitive views or engrave them into the memory of the next generation to describe the process more accurately. Is it any wonder that we keep replicating the errors of the previous generation but do so in a much grandiose manner? Just look at the speculative phase we’ve entered now (credit bubble, real estate bubble, and so on).

It makes all the mistakes our ancestors made seem insignificant in comparison. We burden ourselves with debt up to our necks to purchase items we don’t need and use money we don’t possess to pay for them. The real estate bubble is a classic example of madness and history repeating itself enormously. Individuals take home equity loans against the rising values of their homes and use this to finance their extravagant lifestyles. Is there anything more absurd than obtaining credit to purchase something on more credit?

Mastering the Art and Psychology of Mechanical Trading Systems

Viewing the stock market as a game and understanding mass psychology is crucial for successful trading. As the 12th-century philosopher Ibn Tufail noted, “The masses are swayed by passions, not reason.” This insight remains true today. Effective technical analysis tools should be personalized to each individual’s unique perspective rather than standardized.

In the 19th century, economist David Ricardo observed that “the principles of political economy…partake more of the certainty of the stricter sciences than of most of the other branches of human knowledge”. This highlights the importance of a disciplined, systematic approach to trading. Trend analysis is the most straightforward and effective technique – identifying a new trend and staying invested until it reverses.

Contrarian Investing vs. Mass Psychology

There are two main approaches to trading:

1. Contrarian investing involves going against the crowd. As 19th-century financier Nathan Rothschild put it, “Buy when there’s blood in the streets.”

2. Mass psychology investing assesses periods of extreme emotions, such as euphoria or disgust, in a sector. Positions are taken during these intense times.

Most contrarians take positions as a countermove to the majority. But it’s essential to gauge how many contrarians have become euphoric about a sector.

The Pitfalls of Conformity

Mechanical trading systems appeal to our desire for simple solutions and aversion to critical thinking. However, blindly following such systems is akin to the conformist 9-5 routine that dominates society.

To succeed, we must engage in independent thought and learn from our mistakes. In the words of 19th-century philosopher John Stuart Mill, “The fatal tendency of mankind to leave off thinking about a thing when it is no longer doubtful is the cause of half their errors.” Courageously breaking from the herd is critical to market success.

Unveiling the Phases: Contrarians, Mass Psychology, and Trading Success

Contrarian investing involves going against the prevailing market sentiment. Contrarians believe that the market or a specific stock is undervalued when others are pessimistic, presenting an investment opportunity. However, even contrarians often feel nervous when taking a position, frequently checking to ensure the market has bottomed out. Once the sector shows positive returns, their nervousness subsides, and they become highly bullish, entering a phase of euphoria.

This is where mass psychology becomes crucial. Wise investors should consider exiting the market at this stage, which is likely close to the peak. Understanding mass psychology is an integral part of any successful trading system.

For example, in the early 2000s, many contrarians invested heavily in gold as prices pulled back, believing it was undervalued. However, as the correction intensified and gold plunged from $1,800 to around $1,000, they panicked and started to pray. Today, sentiment towards gold is almost as bearish as in 2003, potentially presenting a long-term buying opportunity from a mass psychology perspective.

Another example is the Chinese stock market, where a study found that contrarians account for 12-14% of trading volume. The study compared the performance of contrarians and trend-followers, demonstrating the inefficiency of China’s stock market.

Critical Principles for Trading Success

1. Master technical analysis (TA) tools: Avoid using TA tools in a standardized manner. Personalize them to suit your perspective and needs.

2. Patience and discipline: Be prepared for extended waiting periods before taking a position. Those who exercise patience can reap rewards in weeks.

3. Independent thinking: Develop a contrarian viewpoint through curiosity, independent thinking, and thorough research. Maintain your out-of-consensus perspective, even if it takes time for your theory to prove correct.

By following these principles and understanding the phases of market sentiment, investors can navigate the complex trading world with greater insight and success. As legendary investor Warren Buffett, known for his contrarian approach, has demonstrated, finding pockets of opportunity in out-of-favour sectors can lead to significant outperformance over time.

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