What’s the Difference Between a Discretionary Strategy & a Mechanical System?

This is a discussion on What’s the Difference Between a Discretionary Strategy & a Mechanical System? within the New to Trade2Win forums, part of the Reception category; SHORT ANSWER ‘System’ is all encompassing and covers position size and where to place stop loss orders etc., whereas, ‘strategy’ ...

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Old Apr 5, 2008, 12:43pm   #1
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What’s the Difference Between a Discretionary Strategy & a Mechanical System?

SHORT ANSWER

‘System’ is all encompassing and covers position size and where to place stop loss orders etc., whereas, ‘strategy’ is just one element of an overall system. However, rightly or wrongly, they are often used interchangeably; mechanical traders tend to favour the former, while discretionary traders tend to favour the latter.

Discretionary Trading
This involves making a decision in the heat of battle, based on your interpretation of market action as it unfolds. If you’re a day trader, this often means making snap decisions about when to enter and exit trades. Procrastinators beware! To be a good discretionary trader, you must be disciplined and calm, and never allow fear and greed to dictate your actions.

Mechanical Trading
This involves using computer software to neatly side step the issue of discipline and emotions. If specific criteria are met, the software generates a buy or sell signal, and/or executes trades by itself. The downside is that it can’t use discretion. In other words, it might generate a buy signal on a day like 9/11, when everything headed south harder and faster than the Olympic gold bobsleigh team.

Mix 'n Match
Potentially, there is a hybrid of the two that offers the best of both worlds. This involves you manually entering and exiting trades according to a predefined mechanical system. On a day like 9/11, you would use your discretion to override any long signals, thus keeping you out of the market when it ‘tanked’ (trader’s speak for dropping like a stone).

Last edited by timsk; Sep 29, 2010 at 2:55pm. Reason: Updating
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Old Apr 5, 2008, 12:43pm   #2
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What’s the Difference Between a Discretionary Strategy & a Mechanical System?

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To attain consistent profitability as a trader, you must have some sort of strategy or system in place. If you’re relying upon gut instinct or a sixth sense to make trades, then you’re gambling rather than trading and the probability of you making money in the medium to long term is very slim indeed. A method to your madness is needed which, ideally, would be written down in the form of a trading plan. This is expanded upon in another FAQ entitled: Is There a Strategy or System I should Use and Where can I Find it?

Strategy or system - eenie meenie miney mo . . .
Before getting to grips with the difference between discretionary strategies and mechanical systems, first we must be clear about what is meant by ‘strategy‘and ‘system’. The two words are interchangeable to some degree, although, as a rule of thumb, the former tends to be used by ‘discretionary’ traders (DTs), while the latter tends to be used by ‘mechanical’ traders (MTs). DTs rely upon the stuff between their ears to decide where to enter a trade, how to manage it and when to exit it. The problem they encounter is that the market is brilliant at tapping into their hopes and fears. Often, this leads to decisions based on irrational emotions, rather than cool, calm and clear reasoning. In other words, it’s all too easy to deviate from the strategy and make ‘shoot from the hip’ type trades based on gut instinct.

By contrast, MTs don’t have this problem, as the computer makes their decisions for them, based on a ‘black box’ algorithm or an ‘Expert Advisor’, (often referred to on the boards simply as an ‘EA’). The advantage of computer wizardry is its ability to trade in a cold and ruthless manner, unswayed by fickle emotions. The problem that MTs have is that computer software can’t (yet!) easily tap into the prevailing sentiment of the market. It can only do what it’s been pre-programmed to do.

The process of acquiring a new strategy or system – regardless of whether it’s free, bought or built from the ground up by your own fair hand, is also covered in the FAQ ‘Is There a Strategy or System I should Use and where can I Find it?’ Before you set off on your quest, you must know what you’re looking for. To do that, you must address the fundamental question of whether you’re a discretionary trader (DT) or a mechanical trader (MT). The remainder of this FAQ will explore the two approaches and touch on a few common denominators.

The MT
Here’s a little test for you. Did you feel a tear welling up in the corner of your eye during that emotional scene in the last episode you saw of Eastenders? Do the palms of your hands get sweaty when your trade is ‘offside’ (in the red) to the tune of just £10.00 on your £100k account? If you’ve answered ‘yes’ to either of these questions, then the MT route might be the one for you. Your options are twofold, either you buy and trade someone else’s system or you develop one of your own. Almost always, if it’s at all possible, the second option is better. Far better! If you’re new to trading and don’t have the technical ability to build your own system, then you will have little choice but to use someone else’s or enlist the services of a programmer.

Time for a reality check
If you think you’ll find something for free on the interweb, or be able to buy something for a few hundred quid, plug it in and let it make money for you day and night – then think again. This simply isn’t going to happen! If it was that easy, everyone would do it. So, be realistic, being a MT and using someone else’s system is not a short cut to riches or a way of avoiding a lot of hard work. Be sceptical of the marketing hype on commercial websites which can be very flowery, often set against a backdrop showing exotic locations, pretty girls and flashy cars etc. To be fair to them, they are in business of selling their EAs and other assorted software, so they’re unlikely to say ‘this may not work quite as well as it says on the tin and you might lose more money than you make’! However, that’s not to say that there aren’t any good products on the market – there are. All that’s required is an application of common sense while conducting your own due diligence. Only reach for your plastic once all the necessary questions are answered and boxes duly ticked. Is there a free trial period? Are there any guarantees? Do they offer a refund if you don’t like the product? Can you see the software working before purchasing? Can you talk to a satisfied customer? Have they had any complaints? etc., etc. For more ideas on how to avoid being fleeced by unscrupulous vendors, check out the FAQ entitled: Can you Recommend a (Forex) Alert Service?

To get started, find and test as many free systems as you can, using a demo’ trading platform. Under no circumstances use a live account to evaluate a new system straight out of the box. The testing process will give you an opportunity to assess the system’s performance, while you’re learning about systems in general and the finer points of trading in particular. Most systems are designed for specific market conditions. Very few will perform well in all markets and all types of conditions. For example, one system might perform well in a trending Forex market, while another does well in a choppy – range bound equities market. Even if you don’t understand the technical programming aspects of the system, you have to know what it’s attempting to do and the market conditions best suited for its use. Fortunately, for the non technically gifted, the world is awash with computer experts who can create your mechanised system for you. But, in order to provide them with the necessary specification, you will need to understand the principles that govern mechanical systems and know as much about the markets as any other type of trader.

The DT
While MTs buy or develop systems, DTs buy or develop strategies. At the heart of a strategy lies the set up, entry trigger and exit trigger. A trade set up is a preliminary condition (or set of conditions) which, if met, validates any subsequent entry trigger. The same basic principles that apply to MTs also apply to DTs. There are no ‘get rich quick’ solutions and DTs who excel do so as a result of long, hard graft. There are numerous free strategies available on T2W and beyond, and an even greater number costing anything from the price of a good book to many thousands of pounds. A good trading strategy needs to be simple to understand and easy to implement. The shorter the timeframe you trade, (i.e. a day trader using one minute charts), the more important this is, as you tend not to have the luxury of time that’s afforded to swing and position traders. The benefit of using a canned strategy – a good one that is - is that it provides new traders with a starting point which will set them off on their own path of discovery.

The great advantage for the DT is the ability to adapt or modify a strategy according to prevailing market conditions. Unfortunately, this is also the single biggest disadvantage, as DTs are forever taking trades they have no business to be in, or not taking trades they should have taken that would have been runaway winners. Once they’re in a trade, their pounding heart or knot in their stomach often causes them to deviate from their strategy. Typically, this results in hanging on to losers for too long, thereby incurring large losses, and closing out winners too soon, thereby restricting profits. Big losses and small profits are the default settings that most DTs start with and often struggle to overcome.

For many DTs, the solution to this conundrum is to introduce a large mechanical element to their trading. This can be as rigid or as flexible as you want. For example, some traders will only take trades if a very specific set of events occur. Others will define say, five things that would, ideally, occur before entering a trade. If all five take place, they take the trade without hesitation. If one element is missing, they take the trade at their discretion. If two elements are missing, there is a presumption against taking the trade, unless there are some other very good reasons for doing so. In other words, where only three or four conditions are met, it’s down to the experience, skill and judgement of the trader to decide whether to go for it or to wait for a more clear cut opportunity. As a rule of thumb, the more experience a trader has, the greater the amount of discretion that may be used. Conversely, new and inexperienced traders are advised to keep the discretionary element to a bare minimum.

MT, DT or a bit of both?
The route you elect to go down will be determined by your interest, personality and technical skills. Most MTs tend to have excellent computer skills. To use a car analogy, MTs not only know how to drive, they can explain – with enthusiasm – how the internal combustion engine works. On the other hand, DTs have little interest in cars in general, and zero interest in how they work. To them, a car is merely a useful tool for getting from A to B.

As has been mentioned in this FAQ, both routes have their strengths and weaknesses and opinions about which is best has caused many an argument on T2W and elsewhere. Some DTs go so far as to say that a purely mechanically based approach can’t work or, if it does, it won’t work for very long. Their reasoning being that the markets are dynamic and constantly changing and that MT systems aren’t very good at adapting to an ever evolving environment. MTs will counter this argument by saying that they run different systems concurrently and stop trading the ones that produce a drawdown and leave the profitable ones to do their thing. So, if this is the avenue that interests you - don’t be put off! As with most things to do with trading, it’s down to you to decide what is best for you. As the saying goes: 'one man’s meat is another man’s poison'.

Last edited by timsk; Sep 29, 2010 at 3:06pm. Reason: Updating
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Old Apr 5, 2008, 12:43pm   #3
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What’s the Difference Between a Discretionary Strategy & a Mechanical System?

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Last edited by timsk; Apr 11, 2012 at 5:32pm. Reason: Updating
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Old Apr 7, 2008, 11:37am   #4
 
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Systems trading is just a consistent way of doing discretionary trading.

The systems trader uses his discretion to come up with a set of trading rules or 'system'.

The rules include: which markets to trade, position sizing, entry points, exit points etc.

These rules are then applied consistently until the trader believes they need to be changed or replaced with better rules.
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Old Apr 7, 2008, 11:53am   #5
 
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Old Apr 7, 2008, 6:35pm   #6
 
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Larry Hite described his conversation with a friend who couldn't understand his absolute adherence to a mechanical trading system. His friend asked, "How can you trade the way you do? Isn't it boring?" Larry replied, "I don't trade for excitement. I trade to win."

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Old Apr 8, 2008, 11:00am   #7
 
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Mechnical traders don't care about between the fine distinction between random and unpredictable behaviour. To a discretionary trader, this distinction isn't minor at all. This isn't meant as criticism, it's just an observation.

The way I see it, mechnical traders do not care about WHY they take a trade, they react on the signal because they believe their system in the long run provides a statistical edge. The discretionary trader on the other hand is aware of the why and takes time to understand the underlying activity. This might bring him to pre-empt his plan at key points.

Confusion sometimes arises from the use of the word 'system'. However, both groups of traders should have a systematic approach to the market, i.e. they know in advance what they are looking for and what they will do if they see it. Although the set of rules for mechnical traders might be more defined in absolute rather than relative terms, both types of traders must acknowledge the fact that having rules is a necessity in order to survive in the markets.

Aspiring traders often think that being discretionary means you're acting on instinct. However, that's a common misconception that can have seriously damaging effects in the long run.
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Old Aug 20, 2008, 12:35pm   #8
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I believe that one can apply good trading principles without having an explicit system and be successful as a discretionary trader. Some of the best traders I know are discretionary traders, this is especially true of day traders or swing traders. Discretionary trading is more fun and can be more gratifying if you have the right personality.

Many people believe that only a human brain can make money and that discretionary trading is vastly superior to systematic trading. Others believe that discretionary trading is inferior and that only system trading works. I hold none of these dogmatic beliefs.

I believe that all successful traders are systematic but that some have internalized the rules they use so that they are able to perform without having to explicitly refer to rules. They may not even be aware of all the rules they use.

Good system traders would learn quite a bit from reading the blogs of discretionary traders. There are many ideas contained in these blogs that can be used to build systems which make money.

I also believe that discretionary traders can learn a lot by building systems and testing out trading ideas in the context of those systems for scientific validation. I have found that many ideas I held as truth did not stand up to the rigor of testing. I’m sure that many discretionary traders find the same when they test their ideas using simulation software.

When I have sat down with discretionary traders, I often find that after a few hours of questions and answers I can get them to describe to me concepts which they did not believe could be tested in such a way that I was able to create a specific trading algorithm that embodied those concepts. This process has always been instructive for both of us.

So I encourage all of you who believe that only your religion is the one true faith to try to learn from the dark side. I am sure that you will find, as I have, that both approaches have their merit and can be the basis of a successful trading career, and that success using either approach comes down to the same core principles: trade with an edge, manage risk, be consistent, keep it simple.
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