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Why it’s dangerous to rely on mechanical trading systems?

Mechanical trading systems

What Is Mechanical Investing?

Mechanical trading systems or just mechanical investing is any one of a number of ways of buying and selling stocks according to pre-set criteria or triggers. The primary purpose of this approach is to remove as much human emotional behavior as possible. Emotions will often negatively impact or cloud rational investment decisions. A systematic investment plan can be partly based on factors that an active investment manager applies, but it is mostly intended to be implemented on autopilot.

How Mechanical Investing Works
Mechanical investing can take many forms. It can be as simple as a set dollar or paycheck percentage amount into a 401(k) account, for instance, or a commitment to buy a stock when its valuation falls to a certain price-to-earnings ratio and sell it when the valuation hits a higher predetermined level.

Valuation markers are common in mechanical investing, but technical analysis may also inform an automated approach to investing. Moving averages, whether simple or exponential, 50-day, 200-day or another time period, can serve as triggers to buy or sell stocks. The Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD) are two other popular signals upon which a mechanical investor sets trading orders.

Whatever criteria is used by the investor, the idea is to remove subjective feelings and second-guessing from trading of stocks (or other securities) and stick with a disciplined approach. Mechanical investing can be considered akin to passive investing, whereby money is normally put to work consistently over time, but at least some sort of thought-out criteria is applied. Full Story

Technical indicators or Fundamental Analysis 

Individuals, especially novice plays are always lead astray when it comes to Technical indicators and trading.  One school pushes technical indicators, while the other school pushes for fundamental analysis. In an abstract way, fundamental analysis is nothing but a mechanical system in disguise. The data is provided in a standard manner, and so anyone can decipher it with almost no effort. Mechanical trading systems put forth a set of rules; all one has to do is follow these rules.  In essence, everyone following this rules could arrive at the same conclusion.

The paradox theory states that one will get exactly the opposite of what one chases.  The same holds true in the arena of technical indicators and trading. Be realistic and do not assume that these indicators alone will always keep you out of harm’s way. We all know that at any given time the masses must lose to be able to feed the big players. That’s why the 90/10 ratio has almost seen no variation over the decades.  90% represents the percentage of losers and 10% the proportion of winners. Hence, it is important to understand the basic principles of basic portfolio management before committing money to the financial markets.

 

Technical Indicators can work but the system should not be fully mechanical in nature

We could go on into great detail about why mechanical trading systems almost always fail, but the theme would be the same.  So in the interest of keeping you awake, we 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.  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 marketplace is nothing but a sweat pool of emotions; lust, greed, power, hate, fear, etc. swirling through the markets like a hurricane.   Technical Indicators should be part of your trading strategy but it should not base your entire strategy on technical analysis.

 

Trading Indicators and even best Mechanical trading systems do not work forever

It’s virtually impossible for a mechanical system to last forever since by designing 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 secretly 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 one’s position and views. As we all know most humans react in an adverse way to bugs, the first thought that springs to mind are to crush them.

 

Even examining the language we use in the marketplaces 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 just 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? Moreover  we 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 our necks with debt to buy goods we don’t need and use the 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?

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. After that one can go about trying to master a  few Technical Analysis tools that are open to subjective interpretation. By personal interpretation, we are referring to the statement that “beauty lies in the eye of the beholder.” Each should see something different when using such an indicator. This TA tool must never be allowed to become standardised. 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 standardised format, this system could work almost indefinitely.

In the end, mechanical trading systems are reflective of our lifestyle and the way we are as a group of individuals; the 9-5 rat race and the zombie-like a 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 colourful style. The only way to break from this way of thinking is to attempt to start thinking and using your mind.

There is nothing wrong with making a mistake because you might learn something as a result of one; perpetuating someone else’s mistakes provides no clues for improvement but only rules for self-destruction.

Customization is  the key when it comes to  using Technical Indicators 

At the very least some customization should be attempted so that the system is adapted to one’s needs. It amazes me that the easiest and most efficient 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.

When using Technical Indicators, it is best to use ones that are not widely followed or if you are using Technical indicators that are widely followed then you should consider adjusting the parameters.

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 involves taking a position against the masses. Mass psychology measures the frenzy periods or times of extreme hate or disgust towards a particular sector or sectors, and then a position is taken during these desperate times.

Furthermore, Mass Psychology measures the level of euphoria in the camps of those that believe in the investment.it will measure how many of the so-called contrarians are now extremely bullish and euphoric in a given sector. In most cases when a contrarian takes a position in a particular industry, he is doing so as a counter move to what the masses are doing. However, the majority of the contrariansare 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 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.

So understanding mass psychology is an important and integral part of a trading system. Secondly, one should master several technical Indicators in order to improve your technical analysis of the Financial markets. Thirdly you need to understand 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. However, you could be rewarded in weeks for your patience.

Published courtesy of the Tactical Investor

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Market Update Stocks (Current price updated every 15 minutes)
SymbolEntry DateEntry PriceCurent PricePositionComments
HTLDJun 201917.1116.33Open1/3rd of a position 17.401/3rd at 18.90 and 1/3rd at 15.05
HAMar 202120.0513.62Open1/3rd of a position 24.90 and 1/3rd at 15.20.
CRSMar 202138.1741.87Open1/3rd at 38.34 and 1/3rd at 38.00.
FISVMay 2021106.73100.35Open1/3Rd of a position at 114.20 and 1/3rd at 99.27
BWXTMay 202158.4960.79Open1/3rd of a position 64.20, 1/3rd at 58.45 & 1/6th 47.10
AYXJul 202168.4240.44Open1/3rd 83.87, 1/3rd at 68.60 and 1/3rd at 52.80
LDOSAug 202190.33109.49Open1/3rd of a position at 96, and 1/3rd at 84.65. Sold half in may at 110.75 for a gain of 22%. Place a stop at 90.00
COUPAug 2021167.1361.15Open1/3rd at 249 and 1/3rd at 219.45, 1/3rd at 110.00 and 1/3rd at 90.10
TFSLOct 202116.8413.79Open1/3rd at 19.74, 1/3rd at 16.79 and 1/3rd 14.01
MGNIOct 202121.0310.68Open1/3rd of a position 26.04 1/3rd at 20.70 and 1/3rd at 16.35
KMBDec 2021131.2136.01Open1/3rd of a position
RGLDJan 202298.55110.67Open¼ of a position. Sold half at 144.30 in Mar for a gain of 46%.
KJan 20226273.07Open¼ at 63.10 and ¼ at 60.90. Place a stop at 60.00. Sold half at 73.50 in May for a gain of 18.5%
AMDFeb 2022107.6670.27Open¼ at 114, ¼ at 108 and ¼ at 101.
CPBFeb 20224352.99Open¼ of a position.
MSFTFeb 2022272.91245.12Open¼ at 300.60, ¼ at 281.05, ¼ at 257 and ¼ at 253
ASANFeb 20224513.51Open¼ at 57.00, ¼ at 43.20 & ¼ at 34.80
FIVNFeb 202289.164.43Open¼ at 96 and ¼ at 82.20
VALEApr 202214.3716.76Open¼ of a position at 15.84 and ¼ at 12.90
WMTMay 2022128.75149.89Open¼ at 133 & ¼ at 124.50
HALOJul 202244.0456.38Open¼ of a position
APDJul 2022237312.1Open¼ of a position
CFFNFeb 202111.68.29Open1/3rd at 12.40, 1/3rd at 11.22& 1/3rd at 11.19
BHEMar 202127.0228.09Open1/3rd at 28.98 and 1/3rd at 25.05.
TRIPMay 202136.9719.02Open1/3rd of a position 43.80, 1/3rd at 39.06 and 1/3rd at 28.05
MOMOAug 20217.95.74Open1/3rd of a position 12.80, 1/3rd, 9.60,1/3rd at 4.90 and 1/3rd at 4.40
CHPTDec 202116.3610.89Open1/3rd at 20.40, 1/3rd at 16.80, and 1/3rd at 11.90
GPNFeb 202212797.65Open¼ 136.90, ¼ at 126.00 & ¼ at119
HIMXFeb 202210.116.96Open¼ 10.27 and ¼ 9.96
GBTCMar 202223.18.76Open¼ 25.80 and ¼ 20.40
ETHEMar 202214.26.47Open¼ at 19.10 and ¼ 9.30
MJMar 202118.955.67Open1/3rd 20.55 and 1/3rd at 17.35.
TLTAug 2021130.85106.95Open1/3rd 145.80, 1/3rd at 131.20, 1/6th at 115 and 1/6th at 116.10
SAAAug 202126.5522.4Open1/3rd at 27.60 and 1/3rd at 25.50
TMFSep 202121.79.59Open1/3rd at 27.06, 1/6th at 17.10 and 1/6th at 15.60
ULOct 202153.151.17Open1/3rd of a position.
AFRMNov 202190.611.97Open1/3rd at 122.40, 1/3rd at 98.40 and 1/3rd at 51.00
WTWNov 2021224.16246.8Open1/3rd at 232.50, 1/3rd at 224 and 1/3rd at 216.00
XRTDec 202178.3264.93Open1/3rd at 91.50, 1/3rd at 83.25 and 1/3rd at 61.50
FINXJan 202226.819.45Open1/4th at 31.50, ¼ at 28.50 and ¼ at 20.40.
SGOLJan 202217.1116.97Open¼ of a position
TQQQFeb 202242.1520.82Open¼ at 56.10, ¼ at 45.00, ¼ at 41.50 and ¼ at 26.00
DEAFeb 202219.2515.24Open¼ at 20.20 and ¼ at 18
VZMar 202248.5736.89Open¼ at 51.55 and ¼ at 45.60
URAMar 202221.3719.49Open¼ position 23.30 and ¼ at 19.45
XBIJul 202273.580.59Open¼ position
BIBJul 20224859.35Open1/5th of a position
  Market Update Options (Current price updated on Mondays and Fridays)
SymbolEntry DateEntry PriceCurent PricePositionComments
IBM230120C00170000Mar 20212.80.19Open1/3rd of a position 4.50 and 1/3rd at 1.11. Sold half at 2.10 for a loss of 25%
KMB240119C00120000Jun 202217.721.63Open¼ of a position
VALE240119C00013000Jul 20222.93.45Open¼ of a position at 15.84 and ¼ at 12.90
QCOM240119C00125000Jul 202225.422.27Open¼ of a position
AAL230120P00010000Apr 20215.10.12Open1/3rd of a position
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Market Psychology: How the crowd always loses in the stock market?

Stock Market Psychology for Dummies: If you have common sense then Mass Psychology is easy to grasp If you understand how the mass mindset operates it provides you with an…
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