Discretionary Models Have Higher Returns?

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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Discretionary Versus Mechanical Trader

I can’t tell you how many times I’ve flipped-flopped on the question of whether discretion is needed in my trading.   Throughout the last three years, I’ve gone from stating that discretionary trading is a necessary component in my trading repertoire to stating that "I am not much of a discretionary trader because of the uncertainty it creates in my mind."  You can reference these ramblings:

http://www.forexproject.com/Blog/Investing_and_Trading/Trading_Performance_Update_and_Ramblings/

http://www.forexproject.com/Blog/Investing_and_Trading/Trading_Quandary_and_Sleep_Deprivation/

http://www.forexproject.com/Blog/Investing_and_Trading/State_of_My_Trading_Address_for_May_2007/

Once again, I am stating for the record that discretionary trading is not for me.  I believe in a very limited amount of discretion in my trading but generally, I really think it’s in my best interest to stick with systematic/mechanical trading.  It creates a sense of order in the market for me when there is none.  When I make a discretionary trade, I immediately become uncertain and doubtful that I did the right thing.  This always turns out bad for me.  I’ll save discretion for determining things like current trend but for entries, exits, stop losses, profit targets, and position sizing, I think I’m much better off being systematic.  I also think that my educational background confirms this.  My background is in computer science and automating/programming repetitive tasks has been common practice in my career.

I told myself when 2008 began that I was going to be trade strictly systematic in January.  So far, it’s paid off and I have not strayed from this.  My account balance is currently up 13% in January.  

How do you know if you’re better suited to discretionary or mechanical trading? I think that as your experience level progresses, you’ll just know.  

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