Mechanical trading

From Traderpedia

A method of trading that relies on objective entry/exit criteria.

Mechanical trading is based on parameters that have usually been historically validated by backtesting quantifiable market data. Once the entry and exit criteria have been defined, the trader should follow the signals exactly. In this respect mechanical trading is almost the opposite of discretionary trading.


[edit] Purpose

Obviously, the main purpose of any sort of trading is to make money! However, as any trader knows, as soon as there is money at stake, emotions have a nasty habit of clouding the trader's judgement and causing him or her not to act in his best interest. By removing the responsibility from the trader of choosing entry and exit points, a mechanical trading system (MTS) is supposed to help the trader overcome this perennial blight of emotion. With emotions eliminated from individual trades the trader may be in a stronger position than one who does not have fixed rules to blindly follow and is this said to be at the mercy of caprice, fear and greed.

[edit] Structure of a Mechanical Trading System

Most MTSs are reactive by design. If a stock or a commodity acts in a certain way, the system assumes that the stock or a commodity will continue to act that way. It generates this conclusion based on the formulas programmed into the system. Some MTSs also compute a large array of indicators in an attempt to increase confidence of an action recommendation. Each order placed is governed by a pre-determined set of rules that are governed purely by market action. In other words, MTSs are techniques that make trading decisions for you. You input the trading data, and the system generates a response that indicates the appropriate action. You buy, sell, or do nothing depending upon the formulas this system uses and operates upon. The latest computer versions of these mechanical systems are completely automated "black box" systems: turn the computer on, start the system, it updates your database, generates trading recommendations, and places your orders directly to the brokers.

[edit] Types of Mechanical Trading Systems

Mechanical systems are usually trend-following or countertrend, while others work best while the market is in consolidation.

Systems that wait for a trend to be established before signalling an entry tend to incorporate moving averages, especially moving average crossovers.

There is a famous trend following system called the Turtle Trading System that was developed by Richard Dennis in 1983. The Turtle Traders’ legend began with a bet between American multi-millionaire commodities trader, Richard Dennis and his business partner, William Eckhardt. Dennis believed that traders could be taught to be great; Eckhardt disagreed asserting that genetics were the determining factor and that skilled traders were born with an innate sense of timing and a gift for reading market trends.

What transpired in 1983-1984 became one of the most famous experiments (nature versus nurture) in trading history. Averaging 80% per year, the program was a success, showing that anyone with a good set of rules and sufficient funds could be a successful trader.

Some mechanical trading systems try and get in earlier by buying or selling breakouts

Countertrend systems tend to wait for price to be overextended in relation to previous action, perhaps by way of a technical indicator such as RSI, and then fade the current move.

[edit] Advantages

  • Several different MTSs can be used simultaneously in order to smooth the equity curve and ensure returns remain consistent over several market conditions.
  • Provide objective rules to follow. Traders who are apt to trade on a whim, or out of boredom, or because they think they know where the market is going can use an MTS to avoid making costly errors.

[edit] Disadvantages

  • Backtesting does not mean that a MTS will work in the future.
  • The market has a habit of ironing out the anomalies that may allow MTSs temporarily to work.
  • Can suffer long periods of drawdown which test the discipline of the trader to stick with the system. Although the rules may be fixed it does not mean the trader will always follow them, especially if subjective judgement warns against doing so.
  • Very dull to trade, no intellectual stimulation. Trader becomes superfluous once the data mining, research and testing is completed.
  • Low win rate, inefficiency, failure to respond to market paradigm shifts

[edit] Constructing your own Automated Trading Strategy

If you are interested in developing your own trading system, click here to view our recommended resources for writing, backtesting, optimizing and trading your system.

[edit] Purchasing a commercially vended Trading System

If you would rather investigate purchasing or leasing a trading system from a developer, click here to view information on finding a legitimate vendor and determining if their system is suitable for you.

[edit] T2W links