Comparison: Discretionary versus Mechanical System Trader

Comparison: Discretionary versus Mechanical System Trader

Table 1.1 compares two extremes in trading: a discretionary trader and a 100% mechanical system trader. Discretionary traders use all inputs that seem relevant to the trade: fundamental data, technical analysis, news, trade press, phases of the moon—their imagination is the limit. System traders, on the other hand, slavishly follow a mechanical system without any deviations. Their entire focus is on implementing the system “as is,” with no variations, exceptions, modifications, or adaptations of any kind.

Exceptional traders are discretionary traders, and they can prob-ably outperform all mechanical system traders. Their biggest advantage is that they can change the key variable driving each trade, and therefore vary bet size more intelligently than in a mechanical system. Discretionary traders can change the relative importance of their trading variables so they can easily switch between trend-following and anti-trend modes. They can instantly switch between time frames of analysis, going from 5-minute bars to weekly bars as their assessment of the trading opportunity changes.
Discretionary traders can make better use of market information other than price. For example, they can react to news or fundamental information to change bet size. Discretionary traders can adjust their perceived risk constantly, so they can increase or decrease positions more intelligently than mechanical traders. These infrequent “home runs” often make all the difference between good and great trading performance. However, for the average trader, being a mechanical system trader probably maximizes the chances of success.

The goals of a mechanical system trader are to pick a time frame (for example, hourly, daily, weekly), identify the trend status, and anticipate the direction of the future trend. The system trader must then trade the anticipated trend, control losses, and take profits. The rules must be specific, and cover every aspect of trading. For example, the rules must specify how to calculate the number of contracts to trade and what type of entry order to use. The rules must indicate where to place the initial money management stop. The trader must execute the system “automatically,” without any ambiguity about the implementation.

Table 1.1 Comparison of trading styles: Discretionary versus mechanical

Mechanical system traders are objective, use relatively few rules, and must remain unemotional as they take their losses or profits. The most prominent feature of a mechanical system is that its rules are constant. The system always calculates its key variables in the same way regardless of market action. Even though some indicators vary their effective length based on volatility, all the rules of the system are fixed, and known a priori. Thus, mechanical system traders have no opportunity to vary the rules based on background events, nor to adjust position size to match the markets more effectively. This is at once a strength and a weakness. A major benefit for system traders is that they can trade many more markets than can discretionary traders, and achieve a level of diversification that may not otherwise be possible.

You can create different flavors of trading systems that use a small or limited amount of discretion. You. could, for example, have specific criteria to increase position size. This could include fundamental and technical information. You can be consistent only if you are specific. This discussion really begs the question of why to use trading systems, answered in the next section.


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