Discretionary vs. systematic trading

This is another great divide in trading, and you need to know very clearly on which side of it you stand. Both are perfectly acceptable, but there is an abyss between them. You can bridge it, but please do not try to jump across while you are in a trade.

A discretionary trader looks at a chart, reads its signals, and places an order to buy or sell short. He monitors the chart and at some point realizes that the signals that prompted him to go long or short have disappeared or reversed. He decides to place an order to exit and completes his discretionary trade.

A systematic trader cannot tolerate this degree of uncertainty. He does not want to keep making decisions every step of the way. His solution is to study historical data, design a system that would have performed well in the past, fine-tune it, and turn it on. From now on he lets his system track the market and generate buy and sell signals.

Neither discretionary trading nor system trading will guarantee success. Beginners lose money with both, but in different ways. When a beginning discretionary trader shows me certain signals on his charts, he is likely to overlook other, just as strong or even more powerful signals that point in the opposite direction. A beginning systematic trader is very likely to fall into the sin of curve-fitting. He spends time polishing his backward-looking telescope until he has a system that would have worked perfectly in the past—if only the past repeated itself perfectly in the future, which it almost never does.

I am attracted to discretionary trading because of its freedom. I find it extremely attractive to approach the market like a blank slate, study broad indexes and industry groups, and decide whether to trade from the long or short side. It is a pleasure to establish entry and exit parameters, apply money management rules, determine the size of a trade, and finally place my order. There is a sense of responsibility and thrill in monitoring the trade and deciding to exit as planned, jump a little sooner, or hold a little longer. I am also attracted to counter-trend trading, but most methods described in this book can also be used by trend-followers.

Systematic traders try to capitalize on repeating patterns in the markets. The good ones know that while things repeat, they do not repeat perfectly. The most valuable quality of a good system is its robustness. A system is called robust when it continues to perform reasonably well even when market conditions change. There is a body of literature on system development, and a good starting point is Robert Pardo’s Design, Testing and Optimization of Trading Systems. Shortly after writing it, Bob became a noted money manager by implementing his methods in the real world. Not too many authors can make that claim.

The decision to be a discretionary or a systematic trader is rarely based on cost-benefit analysis. Most of us decide on the basis of how we feel about choices in life in general. When I interviewed Fred Schutzman for my book Entries & Exits, he said:

System trading works for us because it takes the emotion out of trading. I am not good at making live decisions. I am more of a researcher, a scientist. I can talk to the computer and it can do the trading for me....if we can program concepts, I can continue as an analyst and the computer will trade unemotionally. I am doing the analysis, and the computer trades off my inputs. It pulls the trigger if the conditions exist....System trading is not for everyone—a lot of people do not like handing the power over to a computer. They want to retain responsibility for the decisions.

Paradoxically, at the top end of the performance scale there is a surprisingly high degree of convergence between discretionary and systematic trading. A top-notch systematic trader has to keep making what looks to me like discretionary decisions: when to activate System A, when to pull back System B for underperformance, when to add a new market to the list of those he trades, or when to drop a market from the list. At the same time, a discretionary trader like me has a number of firm rules that feel very systematic. For example, I will absolutely not enter a trade against the weekly Impulse system, described below, and you couldn’t pay me to buy above the upper channel line or short below the lower channel line on the daily charts. The systematic and the discretionary approaches can be bridged—just do not try to do it in the middle of an open trade. Do not change your horses in the middle of the stream you’re trying to cross.

No comments: