Last Updated on March 6, 2021 by Oddmund Groette
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.
In trading there are many decisions to make: when to buy, when to sell, when to take profit, when to take a loss etc. If you are 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 many decisions to make 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.
Four huge advantages of quantifying strategies
As with any endeavor, there are pros and cons to 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 (hopefully). It enables you to overcome greed, 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 make trading complicated. Your inner demons will come out easily when trading.
If you are 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.
Mechanical rules save you time
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 of strategies automatically without spending more time on the trades. You have to look at trading as a business (and time is money).
Mechanical rules help you think in probabilities
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. A keyword here is correlation, which you want as low as possible between the strategies.
Mechanical trading helps your thinking
In order to make a complete strategy, you need to sit down and think about the rules of the strategy. This actually requires some effort. Think of it this way: most traders don’t have any clear cut plan and go from one discretionary strategy to the next. If you can write down your strategy on a piece of paper and quantify it 100%, you are already many steps ahead of the competition.
Take notes and record all trades
To quantify rules you need to spend time thinking and testing. Obviously, that takes time. Additionally, 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 strategy doesn’t need to be complicated to be profitable. Quite the opposite, our experience indicates the simplest systems are the ones that are the most robust because they are unlikely to be curve-fitted.
What is a complete quantified system?
A complete quantified mechanical trading system involves a few elements that need to be considered. What needs to be considered is the following:
What markets to trade:
The first thing you need to do is to look at the market(s) you are going to trade. Why are you trading this market? If you are trading forex, why do you trade forex and not stocks, for example? One important lesson to learn is that markets are different. You are unlikely to get the same profitability by exporting strategies from one market to another. A profitable mechanical system in stocks is almost guaranteed to not work in the forex markets.
Markets are different, and this is logical. For example, the forex market serves a different purpose than stocks. Moreover, stocks are a completely different investment vehicle than forex. Even within the stock universe, you will have problems using the same strategy on all stocks. Commodity stocks, for example, behave differently than consumer staples like Procter & Gamble.
It’s a good idea to trade in different markets. It’s more likely that you’ll perform better the more systems/stocks you trade. No matter your time frame there are several advantages in trading in different markets. One advantage is that markets may correlate less with each other. Many suboptimal strategies are much better than one “best” strategy. Why? Strategies simply stop working from time to time.
How many shares/units/contracts?
You need to adjust the size in accordance with the volatility, not only the dollar size but also the dollar size adjusted for volatility. Two stocks at 50 USD might have 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.
A question you always must ask yourself is this: what is the most likely drawdown? The risk of ruin should always be your main concern to make sure you live to trade another day.
At which level will you buy or short? Are you trading on the close or the open? Or perhaps you should put in a live limit order? Not only is this dependent on the strategy itself, but you must just as well make it practical for your daily life.
As an example, I can use my myself: My swing trading trades at only times per day: the open and the close. I start my systems some minutes before the opening and stop them 3 minutes after the open. I repeat at the close. This suits me well, and I don’t follow the markets in the period in between. Furthermore, by not running my software more than necessary, it limits the potential damage if something goes wrong.
Are you implementing stop or target?
Are you using stops or targets? As a rule of thumb, I prefer to don’t use stops or targets. This is based on two reasons: First, I rarely see that they improve a trading system. They also tend to curve-fit the system. The second reason is for practical reasons as explained above: I only want to run my systems at certain times per day.
What is the exit?
A quantified exit is just as important as the entry, but still, most traders most likely spend less time on exits than entries. Not only the variables for exit are important, but also the timing. Should you exit on the open or on the close?
Does mechanical trading really work?
Yes, mechanical trading does work. But as with all other strategies it requires hard work, discipline, and a fondness for thinking in probabilities. Short-term trading is like a zero-sum game, and you can’t expect gains to come easy. The competition is hard and many competitors have unlimited resources.
What is the best automated trading software?
We recommend using Amibroker, Tradestation, Ninjatrader, or Multicharts. Stick to the software that has a huge number of users, which all of these four have. All these platforms have extensive coverage online with both strategies, support, and help. If you are stuck with some code, you most likely can find what you need online.
We see many coders spending both time and resources in developing their own software. This is a waste of both time and money! It’s not the platform that will make you money, but your abilities as a trader.
I have been using Amibroker for some years, both for testing and live mechanical trading. Amibroker is the best platform for backtesting, but probably not the best one for live trading. Read my thoughts here:
Keep trading as simple as possible, test, and form many hypotheses, work passionately, and you will most likely improve your results. Trading is not rocket science. However, the markets are pretty efficient, so it’s not easy to find trading edges that last. But by using mechanical trading rules you are more likely to succeed.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.