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Discretionary or Mechanical?

By June 24, 2009November 3rd, 2023Active Investor Education, Uncategorized

Part 2 – Mechanical:
The dictionary definition of mechanical reads: “like a machine, as if acting or doing without conscious thought.”

Unlike the discretionary trader, a mechanical trader uses a set of unambiguous rules to guide his or her actions in the market. These rules determine:
o when to buy and sell
o what to buy and sell
o how much money to put into a particular trade at any given time

This means that mechanical traders do not use judgment about when or what to buy and sell and how much to invest in each trade—they act on their established rules without consciously judging the rules or the situation that is signalled by their rules in any way.

If you do not use an unambiguous set of rules for your trading decisions, you are, by definition, a discretionary trader. The majority of traders in markets around the world are by definition discretionary traders. Just about every trader starts out being a discretionary trader. They just don’t see themselves categorised as one because they are unaware of the context of their actions in the trading arena as compared to a mechanical trader.

With the discussion on market variables last week, hopefully you are beginning to realise how badly the odds are stacked against them making money in the markets.

How do you know whether the edge, discretionary or mechanical, is indeed an edge? Most traders do not work this out. Or with great difficulty they eventually work it out after they have done many trades. However, the key is to know this before you actually start risking money in the market. You are not alone if you don’t—very few actually do this before they start trading.

Knowing whether you have an edge or not requires some basic statistical analysis knowledge and knowledge on probabilities. This has been discussed in previous blogs.

The less you have been exposed to trading in your youth until your early 20s, the more important it is that you go down the mechanical path to achieve the goal of becoming profitable on a consistent basis.

In fact, the majority of human beings need to go down the mechanical path to achieve success in the markets. The fact that few do is one of the main reasons why more than 90% of traders close their trading accounts with less money than when their accounts were opened. Simply put, over 90% of traders lose money!

The need for a mechanical step to learn to execute trades at a level that generates profits on a sustained basis is no different to just about everything else that we have learnt in life. Take another mental process like reading. We all needed to go through the mechanical step to learn to read whether it be using a phonetic technique or otherwise. Similarly with physical learning processes like writing, riding a bike and driving a motor car. Trading is no different.

Mechanical trading criteria emanate from the market through rigorous research. Therefore the unambiguous criteria used to enter or exit trades come from a market paradigm. If these criteria have a proven edge then you, the trader, can trade profitably over a large sample of trades by executing the mechanical edge, if you don’t get in the way of the edge.

If you are not using mechanical criteria based on market price action then you are using a paradigm that emanates from a non-market environment, like a societal paradigm. The experiences that we are programmed with for surviving in society will not stand us in good stead in the environment of the market. You have an edge for surviving or flourishing in society, not for surviving or flourishing in the market. You need an edge that emanates from the market. This is what a mechanical edge is.


  • Manuel says:

    Good idea BG… that’s the final set of actions!

  • Gary Stone says:

    Response to Comment by BG:

    One day…..

    The technology exists to do automated order entry and is quite prevalent in the futures trading arena with systems design platforms that have automated order placement functionality into various brokers.

    From a mechanical system viewpoint, it is easier to achieve this with single market trading systems. By this I mean mechanical systems that only trade, say, one of the S&P500 futures contract or, say, Oil. Futures traders design a mechanical system for each futures market that they wish to trade which means that there is only one open trade at any given time per futures market, unless they trade that futures market in multiple timeframes.

    With equities mechanical systems it is a bit more complex as there can always be multiple trends starting across the breadth of an equities exchange at any given time. Making execution of the equities mechanical system 100% automated would require flexible functionality that allows each equities mechanical trader to pre-specify, unambiguously, which entry signal to take over another based on an unambiguous criterion that can differentiate one signal from another.

    Each SPA3 user can do this differentiation right now. It just requires the trader to specify the detail in their Trading Plan and then manually execute it accordingly, flawlessly, without hesitation or reservation. Easier said that done. But that’s an important part of the trading journey which would be lost if it was just about the money and 100% automated.

    Of course, this does require an automated electronic interface into brokers’ online execution plaforms. I am aware of one equities broker in Australia that does have this facility. In the USA there are quite a few.


  • Ralph says:

    Gee your game I would hate to blow up my account because of a computer misfunction I like to see my trades go on and go on as I intend

  • BG says:

    Hi Gary,
    Its an interesting conflict of ideas as to whether to move to full automation to remove any possible emotional attachment or to maintain the manual order process and in doing so using this manual process to work towards the goal of personal emotional non-attachment to the trading process. This consequently could lead onto achieving the ultimate goal of buddhist nirvana (inner peace/joy/harmony through freedom from all desires and attachments) attained by practicing mental and emotional non-attachment to the external world.

    One of the best books I’ve read on this idea of using mechanical trading to seek nirvana:
    “Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis (Wiley Trading)” by Richard L. Weissman


  • BG says:

    Hi Gary,
    I totally agree with your views on mechanical versus discretionary trading.

    But do you think its possible to move to the next level by running a purely automated trading system where there is no manual process at all. All entry signals, exit signals and position sizing are automatically generated and then fed into an automated order sub-system where buy/sell orders are sent directly to the market via a broker’s order server application programming interface? In theory this fully automated system could be ‘let loose’ and just monitored to ensure that the ‘edge’ is still being maintained – this monitoring could also be automated so that the system could provide a warning signal if something is amiss with the edge tracking and so a possible manual review is required.

    This would then remove the potential for manual hesitation due to a trader’s emotional involvement between the receipt of automated signals and the manual order process. i.e. remove the trader from getting in the way of the edge by automating the order process.


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