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Discretionary Trading vs Mechanical / Rules Based Trading

Contents:

  • Definition of Discretionary Trading
  • Definition of Mechanical / Rule Based Trading
  • Difference between Discretionary & Rule Based Trading
  • Which is better: Discretionary or Rules Based trading?
  • Can I make money using only Rules Based Trading?
  • Pros and Cons of Discretionary and Rules Based Trading

Being a retail trader is one of the most rewarding yet hardest jobs that you might have. Once you figure out how to make money consistently, sky is the limit. You shouldn’t be surprised though, that such an attractive and lucrative offer usually hides a catch. 

 

The catch is represented very well in the numbers: 75% up to 90% (depending on your source) of the retail traders lose money. I’m bringing this stats up because this is tightly correlated to WHY retail traders lose money.

 

One of the most frequent theories among beginners is that everything depends on the strategy or the system that they are going to use. I was there as well, trust me. Point is, this believe couldn’t be further from the truth. In fact, in my humble opinion the strategy that you use (the method which tells you when to open a position, for example Moving Averages cross) has no more than 10-20% weight on the final outcome and your bottom line. This is a very interesting subject which i’m planning to develop further in another article or video.

 

 

Now let’s talk about strategies and methods of trading.

DEFINITION: DISCRETIONARY TRADING

 
Let’s start by defining the word Discretion:
 

This is what google has to say on the subject:

discretion
/dɪˈskrɛʃ(ə)n/
noun
  1. 1.
    the quality of behaving or speaking in such a way as to avoid causing offence or revealing confidential information.
    “she knew she could rely on his discretion”
  2. 2.
    the freedom to decide what should be done in a particular situation.
    “local authorities should use their discretion in setting the charges”
 
That being said, discretionary trading is all about being flexible and incorporating any available knowledge, skill or information into the trading decision process. A discretionary trader wouldn’t just look at the two Moving Averages cross to initiate a trade. It would also check, price action, volume, fundamentals and anything else that he or she has in their toolbox. 
 
Naturally, the same concept applies to everything else down the line of the “trade’s lifespan”. From entry, to trade management, risk management and exit. 

DEFINITION: MECHANICAL / RULES BASED TRADING

 
Trading based on fixed rules. The over simplified example could be once again the moving averages cross. Your strategy (which you have thoroughly curated and backtested) tells you that when moving average 50 and moving average 100 cross up, you should be buying, and when the opposite happens, you should be selling. No further analysis. No levels, no fundamentals, nothing. 
 

DIFFERENCE BETWEEN DISCRETIONARY AND RULES BASED TRADING

 
A discretionary trader is going to look at the market or the given asset/chart from many different angles trying to form a well-argued opinion. The purpose is obvious. The more factors (ideally not correlated to each other), coincide and point you to the same conclusion (buy or sell for instance) the better the trade setup is. 
 
Let’s think about that for a second. At the moment of writing this article (January 26th 2022), everyone is anticipating the FED to increase interest rates. This action is expected to have certain effect on the dollar currency, namely to increase in value (to go up). Now this is fundamental analysis. 

 

 On the other hand, we can go ahead and check out what the technical analysis are saying. If you are familiar with market structures or Elliot Waves or anything in this direction you will probably recognize what is going on in the image below. For the sake of this article, let’s assume that our technical analysis is suggesting that we can expect the price to continue higher. 

 

 Each of those opinions or analysis, on their own would count as rules based trading. Once we combine them this turns into discretionary trading. So far so good. Now think about what will happen if you add to this mixture of analysis a few more factors? Is your trading analysis and final conclusion going to become stronger or weaker? 

 
On a side note (related to the question above), machine learning (artificial intelligence, deep learning) is doing exactly that. We feed as much data as possible to the algorithm and then the machine spits out its conclusion based on the data. 

WHICH ONE IS BETTER: DISCRETIONARY TRADING OR RULES BASED TRADING?

 
The answer might depend on your understanding and definition of Discretionary vs Rules Based. For me it’s really simple. I try to extract and use best of both worlds which technically puts me in the category of Discretionary Traders. 
 
I do use mechanical systems and strategies. They are based on mathematical calculations and statistics. However, i’m not solely relying on that moving average cross (let’s stick to the same simple example). I am going to check multiple technical factors and occasionally fundamentals. Here are the most frequent “tools” or methods that I use:
  • fibonacci expansion/fibonacci retracement
  • elliott waves analysis (with a slight twist)
  • supply/demand zones
  • volume analysis
  • pivot points
  • market structures
  • correlations
  • trend lines
  • fundamentals
 
Each of those methods will give me certain information which i’m going to classify as “buy”, “sell” or “neutral”. Then i’m going to make a decision whether i should be buying, selling or sit on my hands. Imagine you have a table like this. Notice how if the method doesn’t give me any of the 3 outputs (buy/sell/hold) i will simply exclude it from the equation (in the image below fundamentals and correlation):
 
DISCRETIONARY-TABLE-ANALYSIS

I love this method of trading for multiple reasons:

1. Numbers don’t lie.
2. Numbers don’t lie.
3. Emotions could be very easily eliminated from the equation because you are arguing (they, the emotions) with something that is quantifiable as opposed to fear or green which are not.

 

 

Once you have this data or scoring system in front of you, things become much clearer and much easier. Remember that you are checking 4-5-6 factors and if we add multi-timeframes, things get out of control and a bit confusing. That’s why writing on a peace of paper or excel sheet is super useful.

 

CAN I MAKE MONEY USING ONLY RULES BASED TRADING?

 
The short answer (unfortunately) is no.  The longer answer is maybe. 
 
You have to understand that the market is changing and evolving constantly. The market is like a living organism. We can identify constants but we are also finding a lot of variables. What do I mean by that?
A constant for example is the nature and direction of the index markets (sp500/nasdq/spy etc). They are going up in the long run.
A variable for instance is the way the price is going up. The more machines and algos are entering the space, the more different the markets will behave. 
 
Bottom line is, almost nothing works forever. Not in trading, not in any niche of life. Essentially there will be change, small one or big one, we don’t know. But if you are not prepared to adapt to this change you are gone. 
 
Relying on multiple factors before you pull the trigger on your Moving Average cross system, in a way is diversifying your risk. To illustrate that with an example, let’s consider the following scenarios:
 
  • Scenario 1: You are using MA cross alone.
  • Scenario 2: You are using fundamental analysis + MA cross.
 
If you had no idea what the FED is expected to do in the following weeks/months, you might be trading both buys and sells of your MA cross strategy and it would make sense, that most of the sells will be losing positions.
If you add the second factor (fundamental analysis in this case) you can stop taking the sells, and only focus on the buys. 
When the fundamental sentiment changes, you can include the sell signals again. Again this is really oversimplified example but I think you get the point. 
 
Discretionary trading = diversified risk.
 
Keep in mind, you will be forced to sit on your hands many times when the market is moving as your scoring system won’t have enough confirmations to get you into the trade. It is part of the approach. 
 

PROS AND CONS OF DISCRETIONARY TRADING AND RULES BASED TRADING

 
DISCRETIONARY TRADING
PROS:
  • Diversifies the analysis
  • Keeps you away from bad trades when drawdown periods occur.
  • Better quality of the setups
  • You can expect a smoother performance curve

CONS:

  • Requires more knowledge
  • Requires more discipline
  • Less trades (if this is a factor for you, which by the way shouldn’t be 🙂 )
  • Harder to backtest (automatically)
  • Could lead to analysis-paralysis 
 
 
MECHANICAL / RULES TRADING
PROS:
  • Simple to follow
  • Easy to backtest (automatically)
  • A software could be used to generate a strategy (set of rules)

CONS:

  • Susceptible to drawdowns and changes in the market conditions 
  • A mechanical based strategy alone is likely to produce smaller gains compared to discretionary trading

CONCLUSION

 

This is a biased opinion,  no matter how objective i try to be. Always make your own research and try to come to your own conclusions. 

 

The way to learn a new skill and become good at something is to get knowledge and training from people, successful in the given profession. If you want to become the next karate kid, you sign up in a Dojo where a skillful master teaches you. I believe that this holds true for about anything out there. That being said let’s consider the people (or shall we say institutions) who are most successful in the trading biz and see what they do – the hedge funds and traders of institutions (excluding executional traders).

 

Think about what they do, how they do it, and why they get the returns they do (besides insider trading and market manipulation lol). 

 

I’m not claiming I know exactly what they do (that would’ve been nice 🙂 ) but there is enough information on the web that gives clues on how their operation is carried. 

 

AI and machine/deep learning is the perfect example. As much data as possible, for best results. Did you know that Jim Simons’ fund collected weather data which helped them build some of their strategies? And that’s just the tip of the iceberg. Have you ever heard about social media scrapping? 

 

 I will stop here and give you the opportunity to dig further on the subject and try to get info on the “big boys” aka “smart money”. 

 

My personal conclusion is that the more info we have, the more educated our guess/bet on the market is. What do you think?

If you have any questions, comments or criticism, please use the comments below. Alternatively you can find me in telegram @yordan_k

 

Happy trading!

 

Yordan Kuzmanov

Chief Trader at Traders Terminal

www.traders-terminal.com