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Tactical Investor is a self-taught Student of the Markets, having widely read conventional and non-conventional texts on all aspects of technical analysis and market timing. He has been studying the markets for over 18 years. He combines mass psychology, technical analysis and a new field of... More
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  • Mechanical trading systems: a ray of light or a cavern of darkness? 2 comments
    May 8, 2010 12:15 AM
    There is a difference between happiness and wisdom:
    he that thinks himself the happiest man is really so;
    but he that thinks himself the wisest is generally the greatest fool.

    Francis Bacon
    1561-1626, British Philosopher, Essayist, Statesman
    We have been lead to believe that mechanical systems and to some point fundamental analysis are the necessary skills to master in order to prevail in the markets. In an abstract way fundamental analysis is nothing but mechanical system in disguise; the data is put forth in a standard manner and so anyone can decipher it with almost no effort. Mechanical trading systems put forth a set of rules and all one has to do is follow these rules; in essence all the players become nothing but robots following a routine. The paradox theory comes into effect now; it basically states that one will get exactly the opposite of what one chases. We all know that at any given time the masses must lose in order to be able to feed the big players. That’s why the 90/10 ratio has almost seen no variation; 90% representing the percentage of losers and 10% the percentage of winners.
    I could go on into great detail about why mechanical trading systems must and will fail and in the process put almost everyone to sleep. So in the interest of keeping you all awake I will keep it short and sweet. Let’s just pause for a second here and investigate the name “Mechanical.” One of the definitions by Merriam’s Webster online dictionary is “done as if by machine: seemingly uninfluenced by the mind or emotions
    Notice the key words here uninfluenced by the mind or emotions. First of all the market is nothing but a composition of a million minds so using a system that’s based on the rules set forth by one man’s mind and worse still devoid of any mental influence is a recipe for disaster. Secondly the market place is nothing but a sweat pool of emotions; lust, greed, power, hate, fear etc swirling through the markets like a hurricane descending on village of huts ready to decimate everything in sight. The above definition of the word mechanical is enough to make you want to run from any such system.
    It’s virtually impossible for a mechanical system to last forever, since by design anything mechanical must and will break down at some given point in time. It’s rather amusing the terms we chose to represent the things we use or to define what side of the markets we are on. It’s almost as if we have nothing but a secret programmed desire to lose syndrome ingrained deep with our psyches. Bullish and bearish, we choose two of the most stupid, dumbest, irrational and easily angered animals to represent whether we think the market will go up and down. Then if we happen to be individuals that favour just one sector we come up with the term bugs as Internet bugs or gold bugs. Why such a disgusting animal to represent ones position and views. As we all know most humans react in an adverse way to bugs, the first thought that springs to mind is to crush them.
    Even examining the language we use in the market places illustrates further psychological issues; scalp, plunge, up thrust, perfect bottom, down thrust, flip, climactic sell off, etc.
    The worst part of all this is that we pass nothing new to the next generation. We simply reinforce these Neanderthal views, in fact branding them into the next generations memory more aptly describes the process. Is it any wonder then that we keep repeating the previous generation’s mistakes but do so in a much more grandiose manner? Just look at the speculative phase we have entered now (credit bubble, real estate bubble and so on) it makes all the mistakes our ancestors made pale in comparison. We leverage ourselves to the our necks with debt to buy goods we don’t need and use money we don’t have to pay for them; the real estate bubble is one classic example of madness and history repeating itself on a gigantic scale. Individuals take home equity loans against the rising values of their homes and use this to finance their extravagant lifestyles. Is there anything more insane, taking credit to buy something more on credit?
    Anyway getting back to the topic at hand; no one is taught to look at the markets as a game and study the mass mind and behaviour of individuals and then learn how to use a few TA tools that are open to subjective interpretation. By subjective interpretation we are referring to the statement that “beauty lies in the eye of the beholder.” Each individual should see something different when using such an indicator; this TA tool must never be allowed to become standardized. If it is, the end is near. The ones that learn to correctly master this tool will come out ahead, however since the method is not available in a standardized format this system could work almost indefinitely.
    In the end mechanical trading systems are reflective of our lifestyle and the way we are as group of individuals; the 9-5 rat race and the zombie like nation where everyone thinks and acts like one. A mechanical system is also reflective of the fact that most of us do not want to think, we want everything handed down to us and when we get whacked on the head we cry like babies. It is for this reason we never seem to learn from history but only look for ways to perpetuate the same mistakes on a flamboyant style. The only way to break from this way of thinking is to actually attempt to start thinking and using your mind. There is nothing wrong with making a mistake because you might actually learn something as a result of one; perpetuating someone else’s mistakes provides no clues for improvement but only rules for self-destruction.
    At the very least some customization should be attempted so that the system is adapted to ones own needs. It amazes me that the easiest and most effective system in the world is not studied or followed more widely. The system I am referring to is trend analysis; all you do is spot a new trend and stay on board till the trend ends. Trend analysis involves the drawing of simple lines; it takes a little practice but is worth its weight in platinum.
    So let’s look at what type of system can and will work in the markets. First of all one has to understand the difference between contrarian investing and investing based on Mass psychology. Contrarian investing is a very simple system as it basically involves taking a position against the masses. Mass psychology measures the frenzy periods or periods of extreme hate or disgust towards a specific sector or sectors, and then a position is taken during these extreme times. Furthermore it measures the level of euphoria in the camps of those that believe in the investment. In other words it will measure how many of the so-called contrarians are now extremely bullish and euphoric on a given sector. In most cases when a contrarian takes a position in a specific sector he is doing so as counter move to what the masses are doing. However the majority of the contrarians are still nervous and keep checking their positions rather frequently to make sure that at the very least the bottom is in. Once the sector starts to take off and produce returns they actually lose this nervousness and become very bullish; in other words they have now entered the euphoric phase. This is where mass psychology kicks in. At this point it will be time for the smart investor to bail out, you may not be selling at the top but you will be pretty close to it.
    Having a basic  understanding  of the concept of mass psychology is really an important and integral part of a trading system.
    Secondly one should master several TA tools and make sure but do not put all your faith on these tools only. Mass psychology should always be used. In other words make sure you are not always on the same side with the lemmings. When the greed hits an extreme point, its time to bail out.
    Thirdly you need to be patient and disciplined. You have to understand that sometimes you might have to wait for months on end before you can take a position, but you could be rewarded in weeks for your patience.

    As irrigators lead water where they want, as archers make their arrows straight,
    as carpenters carve wood, the wise shape their minds

    Buddha
    568-488 BC, Founder of Buddhism

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Comments (2)
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  • user091234
    , contributor
    Comment (1) | Send Message
     
    one of the best articles i have read in the last few years. Keep up the good work
    8 May 2010, 12:21 AM Reply Like
  • Tactical Investor
    , contributor
    Comments (1705) | Send Message
     
    Author’s reply » thanks for the kind comment.
    8 May 2010, 11:41 AM Reply Like
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