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I believe that all of an individualâ€™s accomplishments are integrally linked to the totality of his or her life experiences. As such, all acknowledgments necessarily fall short of their goal. Having said this, I would like to thank family, friends, and colleagues for their support and encouragement in the writing of this book.
In addition, I would like to thank Richard Hom, who has acted as a brilliant sounding board for various concepts through the years; Robert Weber, for his editorial insights; Dr. Kurtay Ogunc, Marcia Epley, Jesse Van Luvan, Barbara Rockefeller, Dr. Russell Grimwood, Neil Brown, Marsha Lipton, Frederic Bettan, Luis Castellanos, and Douglas Coyne; my students; The Oxford Princeton Programme; Alex Moffett; Stan Yabroff of CQG; and my editors at John Wiley, Kevin Commins, Lara Murphy, and Matt Kellen.
I also wish to acknowledge my indebtedness to all the authors listed in this bookâ€™s reference list. If this book has added anything to the fields of mechanical trading systems, trader psychology, and technical analysis, it is as a direct result of their work. Finally, I would like to acknowledge the depth of my gratitude to Sogyal Rinpoche, H.H. Chetsang Rinpoche, and Drikung Kagyu Sangha, whose works have inspired and transformed my work and my life.
Dispelling Myths and Defining Terms
Mathematical Technical Analysis and Mechanical Trading Systems
Appearances often are deceiving.
DISPELLING THE MYTHS: THE INEFFICIENT MARKET AND THE HARD ROAD TO PROFITS
The Inefficient Market
If traders behaved in a rational manner, the market would be efficient and trading would offer few opportunities for consistent profit, but time and again market participants behave illogically, basing their decisions on emotional responses. Perhaps the most compelling evidence in terms of market participant irrationality is put forth by proponents of behavioral finance. Behavioral finance, when traders or investors base decisions on emotions, is diametrically opposed to theories of random market behavior and efficient market hypothesis, which assumes that all market participants behave rationally.1
Recent acceptance of behavioral finance by the academic community2 validates what technicians have known for well over 100 years: Market participants behave irrationally, and it is this emotionalism that leads to stable Paretian price distributions.3 Such distributions are characterized by a greater propensity toward mean reversion than suggested by a random distribution, which technicians capitalize on with mean reversion tools, such as Wilderâ€™s Relative Strength Index, and amplified tailsâ€”also known as trendsâ€”which technicians profit from through trend-following tools, such as moving averages.4
Although the irrationality of markets is why technical analysis works, it
MECHANICAL TRADING SYSTEMS
is also the greatest danger in the execution of a mechanical trading system. Traders must have the discipline to continuously behave in an unnatural, uncomfortable manner to consistently generate profits. This is why mechanical trading is difficult. Discipline and money management means acting like a machine. It means tempering emotionalismâ€”few thrills or excitement, few of the life-affirming things that we as human beings seek. It sounds boring because, if done correctly, it should be boring. In part it is this lack of excitement that makes its successful execution so difficult. However, there are challenging aspects to all trading, even mechanical trading. The most obvious creative aspect of mechanical trading is the process of system development and refinement itself. In addition, in later chapters we will examine discretion over position sizing and how this lends itself to creativity.
Thus, the greatest obstacle to successful trading as a technician is not the ability to discover a successful trading strategy; rather, it stems from the inability of people to take trading signals generated by the mechanical system. Even if traders can train themselves to do the unnatural, uncomfortable thing by adhering to proscribed entry signals, the battle for selfmastery has only just begun; the ability to exit tradesâ€”whether those exits are with profits or with lossesâ€”as dictated by a mechanical trading system is clearly the most formidable obstacle faced by traders.
Taking the Trades: The Psychology of Entry
Successful trading in some ways requires an unlearning of many old psychological behavioral patterns. The vast majority of our life experiences prior to our decision to trade involve the avoidance of pain, error, mistakes, imperfections, and uncertainty and the seeking of pleasure, excitement, approval, and perfection. These previously learned psychological patterns lead us to seek out the â€śperfectâ€ť entry point, which often means either abandonment of our entry level when we discover its imperfections or an inability to execute entry orders due to our desire to wait for the elusive â€śperfectâ€ť entry price.5