This is an extract from the Discretionary Vs Mechanical Trading Strategies lesson in the ACTP online course.
The battleship that is the Forex market depends upon a steady stream of new traders climbing aboard, because for every shiny new Forex sailor who signs up for service, there’s one defeated and disillusioned soul looking to abandon ship, their confidence shattered and cynicism running high. They escape with heads bowed and tails between their legs, wondering what on earth had hit them? Despite trying virtually every strategy and indicator known to man, including those used by exceptionally profitable traders, they’d failed to make any headway. What went wrong?
The simple fact of course, is that their focus is often misplaced. Although there are many excellent trading strategies available from which to choose, there is no such thing as a perfect strategy, or ‘holy grail’ in trading. While most new traders believe strategies are the most important element to successful trading, in actual fact, trader psychology is the key determinant. Make no mistake, trading with a successfully tested strategy is important to overall profitability, but having confidence in the strategy is of greater importance, as is an ability to adhere to a well designed trading plan, and the tenacity to trade through losing periods. Trader psychology is therefore a key factor in determining an individual’s potential for success.
The Catch 22 in this concept is that new traders usually need proof of success before they can hope to be confident in a particular system (or themselves). For some, blind faith is enough for them to commit, but the moment an inevitable losing streak occurs, they take flight. Others are stoically analytical, fearful of every shadow cast by an indicator or the unknown. They second-guess signals, refuse to enter positions, or take profits too early, thereby missing out on the big paydays. It’s really no wonder that the Forex markets have such a high attrition rate!
I’ve discussed earlier, the need for traders to choose a trading method that matches their personality and lifestyle commitments. For example, those who like to take their time making entry decisions should not be scalping five-minute charts. Conversely, traders who enjoy the excitement of making split-second decisions would be ill-advised to become swing or positions traders, because they would be very likely to lose focus and incentive. It’s horses for courses. But not only should traders be matching a specific time-frame to their trading personality, they should ensure the strategies they trade are in sync with their personality type as well. Some traders are more suited to mechanical, rule-based trading than others and it’s extremely important for new traders to understand this principle. It’s essential to choose a system or strategy that matches your personality in order to minimise stress and optimise confidence. With confidence comes consistency, and with consistency, comes profitability.
There are three basic types of trading strategies; fully mechanical, fully discretionary, and rules-based discretionary. Let’s analyse the make-up of each…
Purely Mechanical Trading
Purely mechanical, rules-based strategies (if traded correctly) have the advantage of being able to minimise emotional trading by providing strict entry (and often, exit) criteria. Algorithmic trading robots fall into this category, and many people believe that by allowing a computer program to make all trading decisions, human-based errors will effectively be eliminated.
- Mechanical strategies objectify the trading method and will therefore eliminate errors (with the exception of making the mistake of manually overriding the system).
- Mechanical trading allows for precise back and forward testing.
- Mechanical trading is accurate. The system either wins or loses – there is no ambiguity.
- Mechanical trading minimises emotional attachment. Second-guessing or impulsive trading is eliminated.
- Mechanical strategies remove the ability to make value judgments ‘on-the-fly’.
- Mechanical backtesting increases the tendency of traders to over-optimise, or ‘curve-fit’ the strategy being tested, resulting in unattainable replication of performance under live-market conditions.
- Mechanical trading can cause traders to lose focus and an intuitive ‘feel’ for subtle market changes.
- A mechanical system that worked successfully in the past, doesn’t necessary mean it will continue to work in the future.
Purely Discretionary Trading
Purely discretionary traders use a method of entry or exit that relies solely on subjective criteria. Fundamentalists (i.e. those traders using economic news events, interest rate changes, or geo-political data) are most often using discretion for their decision-making. Technical traders can also be classified as being discretionary if they rely upon their intuition or ‘gut-feel’ to make entry and exit decisions.
- Discretionary strategies are readily adaptable to changing market conditions.
- Discretionary strategies encourage traders to carefully analyze signals before making decisions. This results in a greater focus and attachment to market conditions, which in turn, allows for greater flexibility with entry and exit decisions.
- Discretionary trading builds experience and awareness.
- Discretionary strategies cannot be reliably backtested, since there is always the need to make a value judgment under live conditions.
- Purely discretionary strategies increase the risk to traders of emotional decision-making. It takes time and experience to develop the discipline required to manage discretionary entries and exits
- Measuring performance is more difficult with discretionary trading. All entries and exits need to be logged in explicit detail in order to obtain an accurate performance record of each strategy employed.
Rules-Based Discretionary Trading
Rules-based, discretionary strategies, when traded correctly, combine the best features of both mechanical and purely discretionary trading. This type of trading utilises a set of entry and exit rules, but allows for discretion based on external factors or changing market conditions.
- This technique uses mechanical guides for entry and exit, but allows for flexibility of choice in order to maximize the advantages afforded by the trader’s experience and intuition.
- Rules-based, discretionary strategies allow for re-entries into closed-out positions, resulting in greater returns for profitable trades.
- These systems allow traders to carefully position stop loss levels based on support and resistance levels, or other relevant factors, such as imminent news events, etc.
- There can be a tendency for new traders to move too quickly to a rules-based, discretionary system, which may result in ‘cherry-picking’ and second-guessing signals.
We’ve all heard of the rock band who took years to become an ‘overnight sensation’. Skills and discipline need to be developed over time in any vocation, but this is no more apparent than in trading financial markets. Today’s wealthy trader was yesterday’s patient student, who collected knowledge and experience in a steady, controlled manner.
Remember, successful discretionary trading requires a high degree of self-discipline. This skill can only be attained by first gaining market experience. Attempting a shortcut to success usually results in disillusionment and failure and so the temptation to do so should be rigorously avoided. Until you feel confident about your ability and psychological strength, mechanical trading should remain your preferred option.