Last Updated on October 23, 2022
A lot of the best traders use some kind of mechanical trading strategies and 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 this article, I list the main advantages of using quantified and mechanical trading strategies.
The case for mechanical trading systems can be summarized into six main points: automation, consistency, exploiting the law of large numbers, saving time, probability-thinking, and it helps your thinking/creativity. We end the article by giving you a list of the main parts of a complete quantified trading strategy.
In trading there are many decisions to make: when to buy, when to sell, when to realize a 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.
What you need is to systemize your trading strategies into 100% quantifiable rules. The advantages are many:
Four huge advantages of mechanical trading strategies
As with any endeavor, there are pros and cons to mechanical rules. Basically, there are four huge advantages compared to discretionary trading:
Mechanical trading strategies let you automate
A mechanical system automates the whole trading process – it’s rule based. 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).
Moreover, if you let a computer do your buys and sells, there are practically no limits in the number of strategies you can trade. You don’t need to be good a computer programmer to code, all you need is a couple of weeks with some self-studies.
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. However, you can gain a trading edge by knowing yourself! Your inner demons will come out easily when trading and you need to understand yourself.
How can you understand the markets if you don’t understand yourself?
Mechanical trading strategies give you consistency
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. As a trader you need to have a portfolio of trading strategies:
Mechanical trading strategies let you exploit the law of big numbers
Trading is very much a numbers game. If you have a positive expectancy, you want to trade as many signals as possible in the shortest amount of time. The only way you can manage that is by automation!
Mechanical trading strategies 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. Probably around 80% of your time should be allocated to testing and brainstorming.
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 trading strategies 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, as mentioned above.
Obviously, that takes time. Additionally, the system has to be adjusted from time to time, so-called post-analysis. That is why you need a trading journal.
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.
The main parts of a mechanical trading strategy
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.
The entry-level is a part of a complete mechanical trading strategy
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 two 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?
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?
How and when should you exit a trade? A mechanical 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. Is it the best approach to trading? We believe so – for the vast majority.
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 automation software for mechanical trading strategies?
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 for free.
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.
Mechanical trading strategies in crypto, forex, and commodities
Over the last years, a whole new market has popped up: crypto. Can you make a trading system in crypto? We have developed a few, but the crypto market has changed a little lately. In the earlier years in was more prone to momentum and trend following, while it now correlates more to mean reversion in stocks.
What about forex and commodities? You can develop mechanical trading strategies there as well, but again, these are not as consistent as in stocks. We believe one of the reasons is the lack of tailwind from the overnight edge. Furthermore, both forex and commodities are liable to “macro shocks” to a much bigger extent than stocks, making the strategies less likely to last for a long time.
Conclusion: Mechanical trading has many advantages
There are at least six main advantages of mechanical trading strategies. It helps you automate and you thus save time, and you are more likely to get rid of negative emotions when you are trading.
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.