Discretionary Models Have Higher Returns?
by Trader Rich
I’m posting a well composed comment by Lonely Trader after my posting a couple of weeks ago regarding discretionary versus mechanical trading.
Did it occur to anyone that discretionary trading also includes mechanical models? And did it occur to anyone that automated trading has its own drawbacks? I think as traders we tend to chuck our models too quickly, without really studying them — and, more important, without really putting in the personal effort at executing our strategies according to our rules. I am not saying this about you, Rich, but I think most discretionary traders let themselves down by not putting in enough effort at studying their markets and following their rules — and then after all that wasted time, thinking that letting their software make all the decisions will bring the profits they dream about. Of all the models that I’ve seen, the discretionary models have the higher returns without necessarily increasing risk. The reason for this is automated systems tend to truncate profits because of an inability to intelligently react to market changes. (Granted, there are some very sophisticated programs that now use adaptive neural networks, but these are out of most retail traders’ price ranges…by like millions of dollars!) I firmly believe that discretionary rules-based trading is the most effective way for retail FX traders to make money. Algorithms help, but as decision-aides. And I also think that most traders tend to fail in the execution of those models because either they are risking too much money or they are just lazy about following their rules. It’s also a matter of trial and error. Most people who think they are looking at a discretionary model, or some aspect of it, are unwilling or unable to conduct a thorough empirical evaluation of it. They rarely put in the necessary time to quantify aspects of their model and to quantify aspects of their behavior in executing it. And so they either chuck their models out of frustration (before empirically proving whether it works or not) or they move over to automated trading models — and get caught up in the system-fetishism that plagues so many. Either way, each of us has to make a decision. Will we continue to fiddle around with charts, backtests, and flavor-of-the-month indicators, or will we really put our noses to the grindstone, study the markets, study ourselves, and then execute the plan? It doesn’t matter, ultimately, what course one chooses to follow. Just execute the damn plan!
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This a great comment. I find it very encouraging to keep doing what I am doing and just follow my trading plan. Thanks for posting it.
I think his dim view of automated trading, quote: \’Will we continue to fiddle around with charts, backtests, and flavor-of-the-month indicators\’ is somewhat naive, what he describes is what I would call \’weenie automation\’. Proper automation is a lot of hard work and certainly not the shortcut he seems to view it as. People just can\’t seem to get over the almost Luddite \’heroic trader\’ mentality, most trading volume these days is automated, and there are good reasons for this. All this \’study yourself\’ BS amounts to nothing more than new age mumbo jumbo in my view, you either have the numbers or you don\’t, end of story.
Forex Trader writes: ‘most trading volume these days is automated’
Can you expand on your definition of “automation”?
I can understand that you might believe that most order execution these days is not done via the phone or fax like it used to be a decade ago and most of it is done via a human placing orders online (either using market or conditional orders). I also believe that almost all traders use electronic charting programs and have stopped recieving printed chart packs via the mail well over a decade ago as well. But, I have doubts that most of the volume traded on the FX market is done by some computer program that fills the air gap inbetween incoming prices and entering orders online. Do you have a reference to back up your assertion?
I think individual traders looking to automate also maybe looking for a way to take themselves out of the equation which is perfectly acceptable. We will always be the weak link in our trading plans. We\’ve done hours of backtesting, found an edge, are using sound risk management. But pulling the trigger, when, where, and how hard is entirely always up to the discretionary trader. And we find it extremely hard to do with any consistantcy without emotion. We look to automation to take us out of the equation.
Caprica:
It’s common knowledge that a good portion of volume though the centralized exchanges is machine trading, forex of course is not centralized so we will never have any hard numbers. but one can assume an analogous situation applies. If you want indirect proof of this google around for the ever reducing numbers of traders employed at banks, they now hire CS and math guys instead.
As for the the second part of your question, it seems you actually have little idea of what automated trading actually is, I once again politely suggest you might want to google the term.
Forex trader originally wrote: “most trading volume these days is automated”
Forex trader then writes: “It’s common knowledge that a good portion of volume though the centralized exchanges is machine trading”
Which is it? “most” trading volume or a “good” amount of trading volume?
Look I don’t mean to disrespect your opinion here, but while I am willing to beleive that “some” of the volume on the market is connected to automated trading, I find it difficult to accept that “most” of the volume is due to automated trading.
Most of the money in the markets these days is still money from soveriegn funds lookings after a countries coffers, wholesale funds looking after your mum and dad\’s pension and multinational companies who sell hamburgers, soft drinks, drugs, oil, steel, credit, etc. The majority of players still use old fashioned position trading methods that date back to Grahame and Dodd and about the only high tech thing that has improved is they use a bit of asset allocation theory / portfolio management theory and perhaps they protect themselves with some options or some other structured product. Such funds are usually bound by the simple one directional plays based and asset allocation rules described in their prospectus. Very few prospectus for the really big funds with really deep pockets rarely say anything like \”we use automated trading\” in their prospectus.
Automated trading is usually the area of boutique hedge funds or quant trading desks in large houses and is sold to the market as an alternative form of investment to complement the boring old fashioned single directional play portfolios. Many large firms like Merryl Lynch and friends only operate quant trading desks because their customers ask for it and they think they can collect the management fees. Automated trading tends to operate in specific niches of the market where the speed, patience and objectivity of a computer can outpace a human. For example I would be willing to believe the days of the manual scalper is numbered and trading desks are letting their scalpers go in favour of the Dilbert types who can program.
In terms of explaining the reducing numbers of staff in finance area, in addition to the reduced number of seats for scalpers, the big funds are hiring the Dilbert types to help them balance their portfolios and either sacking half their analyst staff of outsourcing it because they have realised that the overhead of having large analyst services is not giving them enough of an edge for the overheads that they bring.
p.s. If you google the term “automated trading” it is interesting to note that the first page of results is stuff for retail traders or stuff written by academics. It is a good sign of who is using it.