Advantages With Mechanical Strategies
|August 21, 2014||Posted by Oddmund Grotte under strategies|
A lot of the best traders (at least the ones I know) use some kind of mechanical rules in their trading. “Mechanical” implies that the rules are based on some kind of objective rules, usually quantified data. The trader should follow these rules exactly without hesitation or emotion. In this respect mechanical trading is the complete opposite of discretionary trading.
When trading there is a lot of decisions to make: when to buy, when to sell, when to take profit, when to take a loss etc. If using your own judgment this might be tiresome and sometimes very difficult to execute. And for most traders highly unlikely to bring any success. Why? With so much decision making it requires a great intellect to beat the market. You have to fight the market, but also fight yourself. It’s so easy to do the wrong thing if you don’t have objective rules. These rules need to be backtested, of course.
As with any endeavor, there is pros and cons with mechanical rules. Basically there are four huge advantages compared to discretionary trading:
- A mechanical system automates the whole trading process. All the work is done before you open a position, and all you need to do is to do what the rules tell you to do. No second guessing and no panicking. All peace and quiet. It enables you to overcome greed and fear and frustration. You simply take the emotions out of the trade. Of course, this requires that you have a good deal of faith in the system. But if you know it will make money in the long run, it should be relatively easy to implement. Certainly during a period of losses a mechanical system will have an advantage compared to using your own judgment. Humans have a tendency to take the wrong action at the wrong time. Certain personality traits makes trading complicated. Your inner demons will come out easily when trading.
- If trading mechanically, your trading most likely will be more consistent and disciplined. Discipline is what most traders need. It’s absolutely essential that you have some rules when trading. If you trade discretionary it’s more difficult to sharpen the strategy. When having specific rules you can do post-analysis to determine what works and what don’t. It’s also a lot easier to trade many more strategies at the same time. That can smooth the equity curve a lot. Try to use the law of big numbers to your advantage.
- You can save time. You’re not worrying about your trades, you simply execute what the rules tell you to do, and thus freeing time to explore and research other potential strategies. If you have a full time job mechanical trading is strongly advised. If you find many trading edges you can trade a lot strategies automatically without spending more time on the trades. You have to look at trading as a business (and time is money).
- Mechanical trading helps you to think in terms of probabilities. When you understand this, you can better grasp the concept of the law of big numbers. Over a large sample of trades, where one trade is very uncertain, the variability of the end result can be drastically reduced if you have many trades.
The drawbacks is that you have to quantify data to make rules. Obviously that takes time. Second, the system has to be adjusted from time to time, so-called post analysis. And last but not least, it only works if you want to spend a lot of time making a system. But overall, anyone who is good with numbers can make some good strategies with some experience.
A complete mechanical trading system involves the following: what markets to trade, when to buy (or go short), how big position, when to exit a position and perhaps implement a stop loss. Before you design a system you need to set your objectives, which markets you are going to trade and your timeframe.
- What markets to trade: Usually it’s a good idea to trade several markets. No matter your timeframe there are several advantages in trading different markets. One advantage is that markets may correlate less between each other. Remember: it’s more likely that you’ll perform better the more systems/stocks you trade. Many suboptimal strategies are much better than 1 “best” strategy. Why? Strategies simply stop working from time to time.
- How many shares/contracts: When calculating this also have in mind not only the dollar size, but also the dollar size adjusted for volatility. Two stocks at 50 USD might have a completely different volatility. Therefore, a 1000 share position in a historically low volatility stock, might be the same as a 200 share position in a high volatility stock.
- Entry: at which level will you buy or short. This has to be precise: either put in a bid order or a market order.
- Stop or target? Be careful with these two stops. Test a lot of it’s really profitable with such stops. A stop loss can be excluded if you’re trading a lot of different markets or stocks and not using leverage.
- Exit: You either exit like in point 4, or you exit “normally” either for example at at the open or close.
When you have designed a mechanical system, it does not require much time to trade it. However, to make one requires a lot of time. But for most traders this is probably the best route to go to become consistent in trading.