Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

CHAPTER 2

Mathematical Technical Analysis

A Building Block for Mechanical Trading System Development

The general who wins a battle makes many calculations in his temple ere the battle is fought. The general who loses a battle makes but few calculations beforehand. Thus do many calculations lead to victory, and few calculations to defeat: how much more no calculation at all! It is by attention to this point that I can foresee who is likely to win or lose.

—Sun Tzu

Many excellent books on technical analysis provide readers with a comprehensive description of various mathematical technical indicators. This chapter does not attempt to duplicate their work but instead tries to address the essential facets of the most commonly employed indicators, including: an explanation of what the indicators are, why they work, and how they can provide system developers with ideal building blocks for mechanical trading systems.

Although I encourage readers to examine the various mathematical formulas behind these commonly employed indicators, I also freely admit that many traders successfully use these indicators without understanding the formulas on which they are based.

My choice of one indicator as opposed to another is almost exclusively dependent on that indicator's popularity at the time I wrote this book. Again, I focus on the most widely used indicators because the more market participants focus on a particular indicator, the more likely that it will be useful in system development. I usually ...