Plans can be fundamentally and/or technically based and if the latter, mechanical and/or discretionary. The fundamental based plans that I know of are all discretionary approaches; I have never seen a mechanical, fundamental plan but that doesn’t mean they don’t exist.
The best place to start is to define my terms:
- Fundamental plans are based on inputs such as supply and demand, value etc
- Technical plans are based on technical analysis
- Mechanical plans: rule based plans, no trades are taken outside the rules
- Discretionary plans: rule based plans with a rule that says ‘entries and exits need not follow the rules’. In essence, this allows intuition to play a role.
- Subjective plans: a trading style that is totally based on intuition. Most of the pit traders I have met and some of their replacements, the ‘on screen scalper’.
I am a monthly trend discretionary trader – that’s my niche. But in today’s post, I’ll be writing about mechanical plans. I stress that in this area, my knowledge is vicariously derived – from books, my students and my peers who have been kind enough to share.
Before I get into the discussion, there are two points I want to make.
- I subscribe to a view put forward by Mark Douglas: that whatever style best suits an individual, the optimum path is first start as a mechanical trader. The mechanical approach teaches us to trade what we see, not what we’d like to see.
- The style we ultimately adopt is the one that suits our personality. In his latest video, Stephen Pierce makes the point that to succeed in business we first must choose the environment that provides the greatest opportunity for success (http://www.dtalpha.com/talkback/?p=17). Part of the trader’s environment is his personality. As we’ll see later, it’s not only in the realm of trading plans that a trader needs to take his personality into account.
Points (1) and (2) may seem contradictory, but my experience as a mentor suggests otherwise. Traders that move straight into discretionary trading more will confuse ‘intuition’ with ‘into wishing’. It’s worthwhile remembering that intuition is borne from experience of lessons learnt from our successes and failures. So unless you have built up the experience base, your ‘intuition’ is likely to be flawed.
The best mechanical plans I have seen have the following characteristics:
- They contain around three buy and three sell rules: entry, stop and profit taking.
- They are based on some observation about the nature of the market rather than being based on just ‘data-mining’ i.e. some computer generated relationship.
- Sound testing of the system for robustness is a must.
- If the system trades more than one instrument, the testing needs to incorporate testing on portfolio basis. The testing program recommended was ‘Trading Recipes’; this has been replaced by Mechanica Software (http://www.mechanicasoftware.com/).
The best books I have read on the subject are the two by Thomas Stridsman: “Trading Systems and Money Management” and Trading Systems that Work”. Thomas makes a point that I have incorporated into the testing of systems. The testing for robustness is found in the normalization of results and not just by the dollars made or lost. He argues that $100.00 made on the S&P is very different from $100.00 made in oats because of the different volatility between the two instruments. We can take this a step farther and argue that the same can be said about the same instrument in different times. For example in 1987 a drop of 100 points in the Dow was a cause for concern; today, it happens almost routinely.
To normalize results, Thomas suggests we use on a one-contract basis, the result divided by the price initiating the trade: we have a result in percentages rather than dollars. In this way, we compare apples with apples between different instruments and different times.
By their very nature, the best mechanical plans ignore the context in which a trade takes place. Consequently, as long as the environment remains stable i.e. the system is operating within the conditions that suit it, it will make money. Indeed, given human nature, and taken as a whole, I believe mechanical traders will make more money than discretionary traders in this environment.
But in an unstable environment or one in a transitional phase, the mechanical trader will fare worse than the discretionary trader.
In the next blog, I’ll commence the series on discretionary trading plans.