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, you?ll notice that, almost without exception, they all rely to a degree on their own intuition, feel and instinct ? discretion. They may use indicators, chart patterns, Fibonacci levels ? all manner of Technical Analysis tools ? but the setups and trades are filtered through their own perception of what?s 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 ? a brain. And they use it! All traders have a brain even if they don?t all make the best use of it! Although the human brain may not be able to match a computer for sheer processing power it?s 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 discretion?
This can be incorporated into many trading systems – in essence, use a system or methodology you feel comfortable with but don?t 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?
Here?s an example. Let?s say one of your setups is the RSI hooking down after it?s reached an overbought level. Let?s say on one occasion that it hooks when it?s 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 ?in good order? then you might ?give yourself permission? to take the trade. In other words, don?t 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 ? let?s say all your setups are firing and you?re 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 you?re not sure, wait for confirmation that the market has reversed ? a chart pattern, a break through a support level, something that adds credence to the system?s signal.
Now you?re not going to make the right call all of the time ? 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 ? that?s all very well, but I simply can?t trade intuitively. That?s 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. You?ve 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.
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 months? experience, often to the detriment of their trading account, they realise that it?s 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 ? if it was easy, everyone would be doing it. It isn?t and they?re 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 Robinson?s excellent article, The Evolution of a Trader.
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.