Source: Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications (New York Institute of Finance)
The major problem is the failure of the system to recognize when the market is not trending and its inability to turn itself off. The measure of a good system is not only its ability to make money in trending markets, but its ability to preserve capital during non-trending periods. It is this inability of the system to monitor itself that is its greatest weakness.
Another drawback is that no allowance is generally made for anticipating market reversals. Mechanical trend-following systems ride with the trend until it turns. They don’t recognize when a market has reached a long term support or resistance level, when oscillator divergences are being given. Most traders would get more defensive at that point, and begin taking some profits. The system, however, will stay with the position until well after the market has changed direction.
The mechanical system signals can be used simply as a mechanical confirmation along with other technical factors which I mentioned previously. Even if the system is not being traded mechanically, and other technical factors are being employed, the signals could be used as a disciplined way to keep the trader on the right side of the major trend.
Furthermore, mechanical system signals can also be used as an excellent screening device to alert the trader to recent trend changes. The trader can simply glance at the trend signals and instantly has several trading candidates. The same information could be found by studying all of the charts. The mechanical system just makes that task quicker, easier, and more authoritative. The ability of the computer to automate system signals and then alert the trader when signals are triggered is an enormous asset, especially when the universe of financial markets has grown so large.
The major problem is the failure of the system to recognize when the market is not trending and its inability to turn itself off. The measure of a good system is not only its ability to make money in trending markets, but its ability to preserve capital during non-trending periods. It is this inability of the system to monitor itself that is its greatest weakness.
Another drawback is that no allowance is generally made for anticipating market reversals. Mechanical trend-following systems ride with the trend until it turns. They don’t recognize when a market has reached a long term support or resistance level, when oscillator divergences are being given. Most traders would get more defensive at that point, and begin taking some profits. The system, however, will stay with the position until well after the market has changed direction.
The mechanical system signals can be used simply as a mechanical confirmation along with other technical factors which I mentioned previously. Even if the system is not being traded mechanically, and other technical factors are being employed, the signals could be used as a disciplined way to keep the trader on the right side of the major trend.
Furthermore, mechanical system signals can also be used as an excellent screening device to alert the trader to recent trend changes. The trader can simply glance at the trend signals and instantly has several trading candidates. The same information could be found by studying all of the charts. The mechanical system just makes that task quicker, easier, and more authoritative. The ability of the computer to automate system signals and then alert the trader when signals are triggered is an enormous asset, especially when the universe of financial markets has grown so large.