In his book, “Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis,” author Richard Weissman identifies three basic trader personality profiles: trend-following, mean-reversion, and day-trading types.
Weissman enumerates two traits necessary for successful trend-followers: patience and fortitude.
Trend-following mechanical systems hopefully get traders in strong directional moves, and signals typically form when the trend has already begun. A typical entry strategy may be to buy at recent highs or sell at recent lows, in anticipation that the price will make a new high or low later on. This may seem counter-intuitive to the majority of traders who like to pick “tops” and “bottoms,” but that’s what sets trend-followers apart from the rest.
The strength of this method is that if you catch a strong trend, you can come up with huge winning trades relative to your initial risk. But of course, no system is fool proof and there are tradeoffs to grabbing potentially big wins.
As the saying goes, “markets range 70-80% of the time.” That means catching a strong trend can be rare, and sticking to a trend-following system requires that you endure several small losses when your entry signals have you jumping in when the market consolidates or pulls back.
To be a trend-following trader you must be comfortable with potentially having a low win ratio, but as long as your winning trades generate enough profits to outpace your losses, then that’s all that matters.
So the questions you have to ask yourself are, “do I have the mental fortitude to handle more losses than wins AND do I have the patience to ride the winning trades to their full profit potential?” If you answered “yes” to these questions, or if you feel stressed having to come up with numerous trade decisions in a day, then trend-following mechanical systems may be the right entry/exit method for you.
Mean Reversion Systems
Aside from trend-following systems, there are systems that are based on the “mean reversion” theory. In terms of price action, the theory states that on average, markets are more often trading within a range than trend, and when the market goes beyond its average range of historical volatility, it tends to fall back to the middle of that range, or the “mean.” These systems aim to look for probable reversal points (i.e. tops and bottoms) where price movement could change direction.
The major difference is that while trend following systems aim to “ride the trend” for large profits, mean reversion systems normally have an exit in mind based off key support or resistance levels. This means a lot more smaller winning trades.
A couple of indicators used in mean reversion systems are the ADX and Stochastic. The ADX helps identify whether the market is in a trend or rangebound, while the Stochastic indicates potential overbought and oversold conditions that tend to precede a reversal.
The key to utilizing a mean reversion system, especially during the long-term timeframes, is maintaining rock solid discipline. Using this method could put you in the market against a strong trend, which can be psychologically difficult if it doesn’t turn your way. Also, there can be many distractions and obstacles that cause psychological stress for a trader, such as the media and other traders. You must train yourself to follow your system’s rules no matter what and remember that the strength of a mean reversion system is the high probability that markets will stay in a range.
Day Trading Systems
Lastly, we have day trading systems. These can be trending or mean reversion systems, but on a shorter time frame–Weissman cites that these generate signals for trades that last 10 days or less. Market junkies who have a knack for these kinds of fast-paced systems usually look at the hourly time frame or lower to aim for smaller profits and place tight stop losses.
According to Weissman, mechanical systems benefit short-term traders the most as the frequency of making trade decisions arise. By using a mechanical system that already outlines what entry and exit levels to take with pre-determined risk-reward ratios, a day trader is somehow relieved from stress.
However, this is not to say that intraday systems are all sugar, spice, and everything nice. The biggest drawdown to using them is that they are labor-intensive. Traders have to be glued to their screens during trading hours either to be ready to act on valid signals or to monitor/adjust their trades.
Dealing with potentially volatile intraday market action, a trader must be able to quickly make sound decisions. Mental agility is critical for someone to master day trading systems and if you think that you have the capacity to find Zen amid the chaos, you may want to try out an intraday system.
So what’s your trading personality?
You have to remember that regardless of what kind of system you’re using, the market will always find a way to put you in between a rock and a hard place. There will be times that you will have more losers than winners, trades go quickly against you, or you’ll have to let go of some of your unrealized profits.
But knowing what you are comfortable with and finding the system or method that matches your personality will help you better adapt to the always-changing market environment.
So if you think that you aren’t so good in calling shots under pressure, perhaps you may want to stay away from short-term systems. On the other hand, if you think you have the discipline to stick to your plan even when price action goes against you, you may want to try out a long-term mean reversion system.