Combining Mechanical and Discretionary Trading


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03 Mar, 2005

in Getting Started and 1 more

Mechanical systems do not work.

Let me rephrase that. Backtested over several years of data, mechanical systems do not show a sufficiently consistent profit and an acceptably low drawdown for the small trader to trade consistently, comfortably, effectively and economically.

To expand on that further, the results of a coded mechanical system might well show periods of excellent profits but, virtually without exception, they will also have draw-downs that most small traders would not be able to tolerate. In addition, most systems tested over several years invariably have considerable periods of losses, usually running over months if not years, plus long runs of losing trades.

If you start trading a mechanical system at the wrong time, you could face months of losses before it starts to turn profitable. Few small traders have the stamina to do that or to sit through more than a handful of consecutive losing trades.

But, you protest, the trading forums, including this one, are full of people using mechanical systems quite successfully. Apparently so, but if you look closely at these posts you will often see a request for someone to program the system so it can be backtested mechanically. None, to my knowledge, have produced consistently profitable results over any meaningful period of time - although if you know of any which have, please point me to them!

So how can some traders claim success with a so-called mechanical system that can often demonstrably be proven not to be successful over the long term and that other traders fail to achieve success with at all?

The answer is that they use discretion. Their own discretion.

If you look at what successful traders do, youíll notice that, almost without exception, they all rely to a degree on their own intuition, feel and instinct Ė discretion. They may use indicators, chart patterns, Fibonacci levels Ė all manner of Technical Analysis tools Ė but the setups and trades are filtered through their own perception of whatís happening in the market. These are the traders who consistently make money.

Sure, they have bad days, bad weeks, and they have drawdowns but they have one thing that a mechanical system does not have Ė a brain. And they use it! All traders have a brain even if they donít all make the best use of it! Although the human brain may not be able to match a computer for sheer processing power itís far better at pattern recognition, fuzzy and deductive logic, at looking at a wide variety of disparate inputs and signals and pulling all these together to form a conclusion.

Mechanical systems with discretion

In my own trading I have found that the way to success in trading lies in combining a set of trading rules, ie a mechanical system with discretionÖ

This can be incorporated into many trading systems - in essence, use a system or methodology you feel comfortable with but donít automatically take every trade it throws at you. Think about the chart, the price, the setup; ask yourself how you feel about the trade. Does it look right?

Hereís an example. Letís say one of your setups is the RSI hooking down after itís reached an overbought level. Letís say on one occasion that it hooks when itís 1 below the actual overbought level. Do you accept that as a Go signal or not?

If you were trading purely 100% mechanically, you would not. However, if, to you, the other signals look Ďin good orderí then you might Ďgive yourself permissioní to take the trade. In other words, donít restrict yourself by waiting for all the Is to be dotted and Ts to be crossed. Take in the wider picture and make a decision accordingly.

Another example Ė letís say all your setups are firing and youíre ready to put on a trade. Before pulling the trigger, take a moment to look at the bigger picture. Okay, the RSI may be well into overbought territory and starting to hook down but, wow, look at that rising trend. The RSI is quite happy to stay overbought or oversold while the market continues in its original direction so does the price look likely to continue or to reverse? Use your judgement. If youíre not sure, wait for confirmation that the market has reversed Ė a chart pattern, a break through a support level, something that adds credence to the systemís signal.

Now youíre not going to make the right call all of the time Ė but then neither does any system or trader. The object is to use your skill, judgement and experience to make better calls than a purely mechanical system so you get the best of both worlds.

Now, some of you may be thinking Ė thatís all very well, but I simply canít trade intuitively. Thatís okay. Some people seem to have a natural instinct for it but most of us must learn it. It is a skill and it will improve with experience. As you learn, you will be looking at and evaluating the charts. Youíve probably heard this before but there is no substitute for screen time - watch the markets, see how they move and how they react to various situations. Watch diligently and you will learn by osmosis.

Starting out

The first thing you need is a system or method. The Net and trading forums are full of systems. Select one that seems logical and reasonable, one that makes sense to you. Remember, the object is not necessarily to trade every signal in every situation but to look at the bigger picture and make an informed decision about whether or not the setup is valid and is likely to make a good trade.

Many beginners start off by looking for a mechanical system hoping or expecting that it will automatically put them on the road to riches. After a few monthsí experience, often to the detriment of their trading account, they realise that itís not as simple as that.

While beginners can certainly start by looking at mechanical systems, the acquisition of the necessary skills to interpret charts will take a little time. Remember this Ė if it was easy, everyone would be doing it. It isnít and theyíre not. But like most things in life, it is a skill that can be learned and one that will improve with experience.

If you are a newcomer to trading, may I suggest you spend time learning the basics of trading, money and risk management, order placement and a spot of trading psychology? This is all freely available on the Net, particularly in trading sites and forums such as this.

For more about the inconsistency of purely mechanical systems and the necessity to learn how to actually trade, take a look at Malcolm Robinsonís excellent article, The Evolution of a Trader.

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Re: Combining Mechanical and Discretionary Trading

Check this one

Oct 30, 2012

Member (6 posts)

Re: Combining Mechanical and Discretionary Trading

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 donít 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.

Jun 26, 2011

Rookie Member (23 posts)

turtle trader
You can also design rules to tell you whether or not you should be trading a particular system, like creating a moving average of the equity curve and only trading the system when the curve is above the average.

Hello Simon,

Thanks for this, could I trouble you with a few questions?

Is this method a widely excepted technique for defining when to trade mechanical systems? Do you have any links to information about this? Or is it something you've discovered and made work for you?

All advice appreciated,

Mar 13, 2005

Member (1336 posts)