Mechanical Trading Systems – Pairing Trader Psychology with Technical Analysis : [PDF Download]

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“If trend following is such a successful methodology, how can indicators based on the exact opposite philosophy generate consistent profits? The simple answer is that mean reversion indicators, such as RSI and other oscillators, work because they capitalize on the market’s tendency to overextend itself.

Whether the trend has matured and is approaching climactic reversal or is still in its infancy and simply correcting a temporarily overbought or oversold condition, the market has an uncanny knack for separating the less experienced from their money by exploiting their greed, lack of patience, and complacency.

Imagine speculators who saw the bull move early but allowed fear of losses to prevent them from buying the market. As the trend matures, their anxiety and regret magnify in lockstep with forfeited profits until they finally capitulate and buy at any price so that they can participate in this once-in-a-lifetime trend.

Since the thought process that accompanied their ultimate trading decision was purely emotional and devoid of price risk management considerations, when the inevitable pullback or change in trend occurs, greed and hysteria quickly shift to panic and capitulation.”

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