Combining Mechanical and Discretionary Trading
The road to a combined system
If you’re not sure that you can develop your own discretion, you can build up to it by exercising your judgement in a more, shall we say, practical way. For example, before jumping into a trade, see if the price is near a support or resistance level, a fib level, a recent high or low. If it is, this might suggest that although the basic premise behind the trade is sound, the price may not move very far creating a poor risk/reward ratio.
Check if any news is due that might affect the market. Forex, for example, often moves significantly – and unpredictably – on the release of certain news reports so you need to take care when trading around those times.
You can also use the ‘look before you trade’ principle if you work with several indicators. A purely technical trader might want all his or her indicators to be firing at the same time before taking a trade. If you add a discretionary element to your trading you don’t have to do this. You can weigh up the importance of each indicator and even if one is not firing, take the trade if everything else looks right. Or, if one is lagging behind the others but it looks as though it might fire in the next bar or two, you might use your judgement to step in front of the signal and enter early.
You can use your discretion in any situation and apply as much or as little of it as you like. To begin, when your system signals a trade, you might use discretion simply to check the price against support and resistance levels or trendlines. As you gain experience you might take fib levels or pivot points into consideration. As a setup approaches, you might search for candlestick patterns such as dojis or chart patterns such as double tops and bottoms that might confirm the trade or suggest caution.
In essence, what you are doing is using the power of your brain – its reasoning, deductive and intuitive abilities - to adapt your trading method to changing markets. With experience, you will do this naturally, subconsciously. We allow and compensate for narrow-range days, poor volatility, erratic price movement – these and a whole range of other factors that make the market move as it does, factors that standard indicators and technical analysis can’t fully take into consideration when presenting their signals.
We can do this - purely mechanical systems can’t. Self-adapting and self-optimising systems attempt to do it but they are not consistently successful, and there is a whole raft of Artificial Intelligence, Neural Network and Genetic Algorithm software that aim to analyse markets to the Nth degree to create successful trades but none can match the mind of a trader well-tuned to the market.
Like any trading system, it’s possible to lose money with using a combined mechanical/discretionary system just as easily as you can make it. To make money, your judgement must be correct and this will only come with practise and experience. However, you can be sure that blindly following a mechanical system will not, in the long term, make you profitable.
Also remember – the entry decision is only part of the trading process - and some would say only a small part at that. However, without a method you have no trades at all so the system remains an essential part of the plan.
By combining discretion to your trading rules you will begin to develop your own trading style. Your decisions and judgement calls will be based on aspects of trading that appeal to you and that you are comfortable with. It can be a self-reinforcing process. As you make successful decisions, you become more confident about them which, in turn, makes you more comfortable with using your discretion.
If you have any questions or comments, please feel free to contact me.