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Why mechanical?

Posted: Sat Jul 12, 2003 6:38 am
by damian
What makes a trader take a mechanical route rather than discretionary? It appeas that there are traders in both camps that make money. If both work, why use one over the other?

I recently read Alaxander Elder's Come Into My Trading Room
A system trader develops a mechanical set of rules for entering and exiting the market. He backtests them and puts them on autopilot. At that point, an amateur and pro go in opposite directions. An amateur, fightened by the market, feels relieved that a system, either his own or bought from someone else, will free him from worry..."
To some degree, this is probably true. Many people end up trading a system that is not robust and which posses a risk characteristic that does not suit them personally. They probably end up having a bad experience as a system trader. He goes on to explain that a system is ok in a way, so long as it is always open to human intervention and discretion.
Automatic systems do not work because the market is not a mechanical or electronic entity that follows the laws of physics. It is a huge crowd of people acting in accordance with the imperfect laws of mass psychology.
From my perspective, this is exactly why proper mechanical methods work. Whats more, the mchanical method allows you to be removed from the mass psychology. With discretion I could filter out some trades that tuened out to be losers, but the reverse could also happen. The net outcome of my discretionary intervention would be a function of my consistent skill, trade after trade, month after month, drawdown after drawdown. On the other hand it could be a function of my luck at predicting the future....

I note more and more these days that a system trader is not fussed whether another person trades on a discretionary basis. But I am finding more discretionary traders who just can't keep their face calm when they hear someone trades on a systematic basis. There seems to be assymetrical negativity.

I really enjoy discretionary trading, however I prefer mechanical methods as they are independent of human weakness and error of judgement on a trade by trade basis over a very extended period of time and. A good system provides the clearest of road maps, and a good map will not get you lost.

This is what I preach....

Posted: Sat Jul 12, 2003 9:54 am
by TradingCoach
Trading a mechanical breakout system can provide invaluable experience. The average net profit for the majority of these systems is quite low, so they may not guarantee a FAST road to riches; but they serve as a superb vehicle to gain a wealth of experience in a very structured format.

If you are going to trade a mechanical system, you must be willing to enter all trades! It is impossible to know which trades will be winners and which ones losers. Most traders who "pick-and-choose" have a uncanny habit for picking the losing trades and missing the really big winners. The hardest trades to take tend to work out the best! With most systems, a majority of the profits come from less than 5% of the trades.

Though most breakout methods have a high initial risk point, their high win/loss ratio makes them easier to trade psychologically. You might get your balls handed to you often enough on the losers, but, fortunately, big losses do not happen THAT often. Further, if trading a basket of markets, as one should with a volatility breakout system, diversification should help smooth out the larger losses.

Posted: Sat Jul 12, 2003 10:58 am
by Bollinger
Somebody asked Larry Hite at the MFA conference in Chicago about a month ago whether he thought discretionary or system based traders were better to invest with and his response was that everyone's a system trader. As he put it, if someone's making money using their strategy, they have rules they follow to exploit whatever market inefficiency they've found.

I agree with this. I personally trade three different styles. One is a purely mechanical longterm trendfollowing strategy in the traditional sense. Another is an S&P 500 option selling program that may be considered discretionary by most -- but I trade it by applying a strict set of rules that tells me when to get in, when to get out, and how many contracts to put on. Ditto for my third strategy, which is carry trading for currencies. All three of these strategies are bound by rules that define the key decisionmaking processes.

Posted: Sat Jul 12, 2003 3:48 pm
by edward kim
I second Bollnger's thoughts in that in the back of discretionary traders' minds, they (like mechanical traders) also have some sort of plan, framework, or "system" that they are adhering to.

The psychological strength of all types of great traders are incredibly high. I believe the biggest difference is that many great discretionary traders have more of an aggressive, charismatic style, while almost all great mechanical traders have a remote, calm demeanor and trade with ease. Most individuals I don't think can withstand the pressure of discretionary trading - it requires extreme clarity, especially when the markets are gyrating. I think it's much a little easier (not much though!) to try to stay detached and calm when things get volatile.

The biggest problem that I have had in the last 10 years of trading is that I:

1. did not ANY plan whatsoever
2. had a low psychological profile
3. was too emotional while trend-following

Having a volatile and emotional personality while following trends long-term is NOT good in my opinion. So I reworked myself, and I am better at being calm while trading mechanically. Now, I have positions in New Zealand dollars and Five-Year Notes. My equity doesn't fluctuate much from day-to-day.

Booooooooring. And I feel much better about it - maybe that's the way it should be.


Posted: Sat Jul 12, 2003 8:59 pm
by Kiwi
I saw Damian's post last night and wanted to reply immediately -- but my wife got the better of me :lol: I wondered if he was influenced by the amusing but at times obscene conversation going on over at Chuck's board.

I started my trading career as a relatively ineffective discretionary trader (my first 5 trades were of course winners). After that I experimented and in the search for diversification I became a system trader for 3 years ago. And now I am increasingly earning my money from "discretionary" trading. The reason for this is that end of day system trading at 2% position risk seems good for 50-100%pa whereas very short term trading may allow you 3-10 opportunities to risk 1% of your capital per night which translates to over 1000% pa. Systems to extract money from intraday markets didnt impress me much and I was much more successful in searching for discretionary approaches to this opportunity.

To trade either approach successfully you must gain control of your mind and emotions. The nature of the control is somewhat different (get used to drawdowns and never interfere with your system vs don't sell too early or ride your losses, say) but it is all about discipline and emotional maturity. I think that eck overdramatises the style differences but that they are there in some cases (see below).

When I started discretionary trading I thought that you made the decisions day by day (eck's flambouyant trader). In some ways this style is likely to characterise the "speculator" and often the intraday "loser" :( What I learnt over time was that a "discretionary trader" determines his or her rules outside of trading time. Then, during trading time, they implement their rules almost like a robot. This is where I am now, allowing very little discretion while I trade. I hear of people applying discretion in the chat rooms during the trading day and then I hear them lose. Also, when you start discretionary trading you need to use very few setups (1 is good) and test them just as hard as you would test a computerised system. So its still system trading - its just in paper and mind.

Mark Douglas then suggests an intuitive stage to follow once you are a really successful rule follower. At this point he says you have your emotions and motivations working for you so you don't make choices for the wrong reasons. Brett Steenbarger in his recent book develops this further and theorizes that you need to see a lot of market action so that your (subconscious?) mind can detect the additional elements that mean that this is not the time to follow your rules exactly.

I find that I agree with Bollinger. To me, a disciplined system trader and a disciplined discretionary trader are not that different. And those who argue the point with too much emotion seem to me to lack the control I would expect of successful traders!

There are lots of ways to take money from the market 8)


Posted: Sat Jul 12, 2003 10:31 pm
by Frank
Although I have not traded mechanically at this point, and have not performed with extremely profitable methods using discretionary trading –I found this topic interesting because I constantly ask myself the question about which is better – Discretionary or Mechanical trading. I just finished reading Nicolas Darvas book on “How I made 2 million in the stock marketâ€

Posted: Sat Jul 12, 2003 11:29 pm
by damian
These are good responses.

I certainly do not think that one means needs to defended over the other. Just like water finding its own level, I think that a serious mature trader will find their own speculative means, and for the right reasons. Once that state has been researched I do not think there is any need to argue the toss as this would be fighting nature. There is balance available for everyone, but a a degree of oscillation is needed before balance is determined.
Frank wrote: If your mechanical trading system is performing well (making you money), is there a feeling that there is not as much stimulation or creativity in trading that way - than actually making the money by signals you see and not the system? If so, does this cause you to find another way to make money in the market that doesn’t use 100% mechanical signals to feel satisfied?
Franks comment is one that has been on my mind of late and has been the cause of me doing dome double rethinks about my true motivations. I have decided to venture into a little discretionary trading that is governed by the same systematic rigour as described by Bollinger and Kiwi John. My motivation is that I feel I have become extremely detached from the markets via my systematic trading. Part of me missed analysing a chart using some pre-formulated rules. But more importantly, I think in the long run I will be a better system designer if I expose myself directly to more human decision making... some discretion. I want to get my hands a little dirty making some money whilst observing greed fear and hope in myself and in others (the chart). I think this will make me a more mature system designer.

My system is a car with no driver and I am merely a passenger that presses a button when told to do so. In a real car a passenger can calculate how much fuel is needed, time to destination etc. However such a passenger could never design and construct a good vehicle for the purpose of making short trips in the city where traffic is heavy, or off road travel where there is lots of mud, and reading lost of books will not help.

Another analogy: a good HQ battle strategist needs to have experienced the lot of a tired soldier, the weight of his weapon, the effects of bad visibility or dense vegetation.

My understanding of the way markets behave and why they do so is slowly weaking and I think this may be one of the reasons for the rubbish medium and short term systems that I create.

Posted: Sun Jul 13, 2003 12:21 pm
by Sir G
If your mechanical trading system is performing well (making you money), is there a feeling that there is not as much stimulation or creativity in trading that way - than actually making the money by signals you see and not the system? If so, does this cause you to find another way to make money in the market that doesn’t use 100% mechanical signals to feel satisfied?
While it’s great to evolve one’s trading, I think one should be very careful of any feelings that may entice them to detour from what is currently a level of success. Think about the difference in the level of ability Micheal Jordan has playing golf or baseball vs. basketball.

If we got into trading to make money, and we have navigated the waters and developed mechanical ways to extract money from the markets, we have begun our journey of success. At that point, the quickest path between success and more success is a straight line.

If we find we have unfulfilled desires from successful trading, we might want to find other endeavors to stimulate us and to release our creativity, outside of the trading arena. Of course we can always spend it developing ideas into other areas of trading, which will translate into better mechanical systems.

When everything is going the way we were hoping/planned it would, we should be very suspicious of finding it not good enough and deviating from the very plan that got us where we wanted to be. These feelings and urges may very possibly have their roots in self destruction and not in self enrichment.

Do what it takes to continue to evolve, but be very careful on which forks in the road you take.

If you have found that in the past, your life has many dramas and a large number of almost “grabbing the brass ring,â€

Posted: Mon Jul 14, 2003 1:14 am
by damian
damian wrote: Franks comment is one that has been on my mind of late and has been the cause of me doing dome double rethinks about my true motivations
Hmm, after Gordon's post I will be doing some quadruple rethinks just to make sure. Gordon, thanks for the great post.

Posted: Mon Jul 14, 2003 1:01 pm
by Jester
Gordon brings up many excellent points, thank you, and I agree. If you have a system that works for you, and will get you to your goals, why change it by adding a new level of complexity (i.e. discretionary trading)? I can't do both.


Posted: Mon Jul 14, 2003 6:55 pm
by Kiwi
I also enjoyed Gordon's post (one of your best G) so I evaluated my reasons.

My basic plan was to make at least 35% to 50% per annum with drawdowns of 30% and delays to new equity highs of 9 months. So I trade 2 systems over about 15 different contracts. The only problem with that is that with Sept 11 and the two US wars it underperformed previous periods (high volatility and short term peaks not captured by the systems).

So the question I asked was "how can I fill the gaps". What I needed was trading income to fill the gaps for the long term systems. I looked at the S&P systems, anticipation etc and talked to futures truth and my brokers about their "real" performance - and decided that this wasnt it.

So I started looking at short term discretionary approaches. I found one and started testing it. It tested well (years of day by day one step at a time applying the rules and recording the result). So I traded it at 1/10th size and for 2 months and it had no surprises, made money month by month. The returns were about 100% per annum but with no real money management or portfolio theory applied to it (discretionary traders seem to trade rather than thinking this stuff through). When you apply these you find that you can trade 3 different contracts with the system and the drawdowns dont correlate so you can trade 3 for the capital of 2 (just like we do with systems :-)). Also the max drawdown under montecarlo was very low ... so multiply by 1.3x the postion size and its still low. Result: trade 3 different contracts with returns substantially over 100% and no losing period over 25 days in last 5 years.

The magic of short term discretionary is that you can risk 1/2% of your equity 5 or 6 times a day and thus if you make an average of 1/2% to 1% per day (say) which would give a return of 300% to 900% per annum. The risk is that you personally may not perform up to your test (and this does seem to be a huge risk). The other one was pointed out by ChuckB a while ago - that your system doesnt actually have a long term positive expectancy but I think that discipline problems are more likely to have killed most discretionary traders.

OK. I confess Jester: My goals have expanded! Its worth doing for the return IMO. But why continue with my long term systems? Comfort I suspect. What say you Sir G?


Posted: Mon Jul 14, 2003 8:38 pm
by Sir G
Kiwi wrote:But why continue with my long term systems? Comfort I suspect.
I hope you meant the comfort of exploiting opportunities! :wink:
Kiwi wrote:What say you Sir G?
I think you have evolved your trading and the way you went about it is a very good model for others (including myself) to follow.

As they say in New York..... Bravo!