Discretionary vs Mechanical Trading – Some Unintuitive PROs and CONs

Discretionary vs Mechanical Trading – Some Unintuitive PROs and CONs

Every seasoned trader has a strong opinion – is it better to be a discretionary trader, or a strictly mechanical trader?  Or is it best to be somewhere between the two?  Every competent trader I know, has become self-aware enough, that they know the answer that is right for them.   It’s a good question to ponder, early in your trading career.  The PROs and CONs aren’t all intuitive, and it’s important to reflect carefully on each, to know which trading method suits your personality, skills, and competence level.

First, let’s understand the terms: Discretionary and Mechanical Trading.

Discretionary Trading – Makes use of data which surfaces in the market real time, to subjectively decide either to take the trade, and/or alter the trade once it’s taken.   The rules, if any, are “loose.”  Trading is often more emotional.   Traders might use data/info that isn’t quantifiable.  Traders might use different criteria from one trade to the next.   Often, the insights used to make the trading decisions are derived more from watching the markets than from rigorous back-testing.   For example, a discretionary trader might go long when the chart pattern “feels good,” size the trade per their confidence at the moment, then, after they’re in the trade, figure out the stop & target, adjust the target & stop a few times through the trade, and then decide mid-trade to exit because the price pattern “looks bad” for the trade at that moment.

Strictly Mechanical Trading – Traders do exactly what their pre-designed system instructs.  The trading system used makes objective decisions based on quantified data.  Often traders aren’t emotionally invested in whether the markets move up or down, or whether they’re “right” on any one particular trade.  Traders have pre-defined rules about all aspects of every trade, and follow them.  Traders usually are not emotional about any one trade; generally have a viewpoint that is grounded in a belief that the system they’re trading will be fruitful, over a large number of trades.  And traders never change the data/indicators/etc. used, without completely retesting & re-vetting the entire trading system.    A strictly mechanical trader will trade per their pre-determined comprehensive set of rules (most likely determined through rigorous back-testing,) taking the entry exactly when the system dictates, using sizing, targets, and stops per the system’s design, and stick with the system’s set of rules until a pre-determined exit condition arises.  Generally, traders trade all the market days and hours that their system used during development & back-testing.

Sometimes, you’ll hear the terms “systematic trader” and “mechanical trader” used interchangeably.

Let’s consider the PROs and CONs

Discretionary Trading, PROs:

  • Over time, you’ll get a sense for market action, and the “moods” of the market – if accurate & helpful, it might increase profitability.
  • You can adapt quicker. When you think you’ve learned something about market action, you can incorporate that knowledge on the very next trade.
  • It’s profitable if your instincts are very well developed, focused, and accurate.
  • It’s exciting, managing individual trades on-the-fly. It’s fun.  You’re actively engaged.  Discretionary trading gets the blood going.
  • It’s somewhat less stressful during a draw-down, in a way, since you might have hope that all you need to do, is to make one tweak to your trading, and all will be well.

Discretionary CONs:

  • When watching the markets & price action, it’s easy to project your own bias & see things that aren’t there.
  • You’ll be crafting your trading ideas from watching a few dozen, or perhaps a few hundred, trades, rather than back-testing against thousands and thousands of trades.
  • Price action in the very short time frame is essentially random. When you look too hard, it’s easy to see patterns in these small data sets of random action – patterns that aren’t really there.
  • Psychologically, there is a huge temptation to “defend” your opinion on an individual trade. This could easily result in your, for example, widening stops at the wrong moment.  Alternately, during a trade, you might become disenchanted with the trade, and perhaps exit early based on the feeling of disappointment you have at the moment.
  • There’s a temptation to make it out to be a fight (you against the market, or Bulls against the Bears.) It’s not a fight. It’s just an auction system, which occasionally has order imbalance.
  • You’ll often make emotions-based decisions – usually not good for the account balance.
  • You’re likely to trade identical setups, in different ways, based on your emotional state. Let’s say a setup occurs at noon, you take the trade, and it’s a loss.  Then at 2:00, the same exact setup occurs, but you’ll be less likely to take it, since you’re feeling scared, or feeling the hurt of the sting of the prior loss.   It’s human nature, but it’s not logical or intelligent.
  • Your intuition is more plastic than you think. Let’s say you study 300 trades on paper & develop an intuition about market action, and then start to trade on that intuition.  Then, you watch, in live time, and feel the emotional highs and lows, of 10 trades that don’t conform to the norm of the 300 that you’d studied prior.  Your intuition will change significantly.  It shouldn’t.  Those 10 new trades are really just 10/310th of the dataset, but human nature will make you weigh them much higher, as though they were, say, half the data set.   In this case, your intuition was TOO plastic.
  • You’re not as smart as you think you are. It’s been shown, over and over again, that most people think they’re smarter than most other people.   Just search for papers about the Dunning-Kruger effect, or about Illusory Superiority.  As a new discretionary trader, you’ll likely start off with an inflated incorrect assessment of your own trading abilities, and immediately be thrown into competition with people who have honed their insights through watching thousands and thousands of hours of market action.  Unless you’re truly exceptional, it will likely not end well.
  • It’s nearly impossible to learn, in a valid way, from the results of your trading. The sample size is too small, and in effect you’re altering variables when using discretion, so logically nothing can be learned.

Mechanical PROs:

  • You WILL be disciplined.
  • There’s no second guessing required. Fewer decisions are to be made in real-time, freeing you up to trade more, or do other things.
  • It’s much less taxing emotionally, on a trade-by-trade basis.
  • The profitability is determined by the quality of the system being traded.
  • You needn’t have deep insights about market price action – you just need the skills to execute trades properly.
  • The randomness of human nature won’t be present.
  • Assuming you’re disciplined in your trade execution, and assuming the system you’re trading is a valid, properly vetted, quality (and not-overfit) system, it’s reasonable to think your returns will be more or less in line with that predicted by your system. With mechanical trading, assuming it’s done properly, there actually IS a reasonable assumption for returns.
  • Returns, for better or worse, should be reliable, relative to discretionary trading, particularly if you’re constantly changing the logic, intuition, and insights you use in that discretionary trading.
  • There’s less of a temptation to fall into gambling-type behavior.

Mechanical CONs:

  • It’s not as fun. There’s no “rush” of making quick decisions on-the-fly.
  • There is a feeling of not being in control, and, certainly, angst when intuition tells you to modify the trade.
  • You have to have faith in your system. If you don’t have faith, you’ll either slip into trading the system on a more discretionary basis, or stop trading the system unfairly after a short draw-down.
  • It’s very emotionally difficult, when considering your overall conviction to your system, during draw-downs.
  • It’s very hard to know when to shelve a trading system that you’re trading mechanically.
  • There’s a risk of becoming complacent about the design of the system you’re trading. Sometimes, systems do need to be updated or tuned (albeit slowly.)  If you’re trading a system mechanically, you might not have occasion to think about the underlying design & ponder how to re-design it per the evolving market action.

It’s actually a spectrum.

In reality, there is actually a sort of spectrum, with strictly Mechanical Trading at one end, and completely Discretionary Trading at the other.  Most traders would place themselves somewhere along the spectrum, rather than at either end.  And that’s fine.

For me, I believe that the best methodology is (again, for me personally) to trade mechanically.   I sometimes still use some discretion in the timing of entry and exits, and sometimes do trades based completely on discretion.  But I recognize that it’s best that I evolve to be as mechanical as I can be.   The motivation for me is twofold:  1 – I believe from an academic perspective, that mechanical trading will yield the best results for most people myself included, and 2 – I’ve just simply grown tired of the emotional ups and downs that come with second-guessing your decision while using discretion in trading.

For newer traders, the advice you’ll hear most often, is to stay away from discretionary trading.  It makes sense that it’d take a lot of hours watching charts to gather the insights and intuition that you need, to do discretionary trading profitably.  So until you get all those hours in, it does seem to make sense to be more mechanical.   Even when newer traders tell themselves they’ll follow a system mechanically overall, it’s a huge temptation to override individual trades when the price patterns just simply don’t seem right.

As a new trader, you need simplicity.  With discretionary trading, at the time of entering a trade, there are at least five very important decisions to be made, all within seconds:  determining the stop level, the target, the time stop, position size, and simply whether to take the trade or not.   Discretionary trading is a complex thing, with many opportunities for making errors.  As a new trader, in the heat of the moment, you’re more likely to make errors when entering trades.  With mechanical trading, you need only execute the trades as per the system’s guidance; there are no decisions to be made in the heat of the moment.

What’s the right choice?

So, in the end, what’s right?  What’s right is what’s right for you.  Do some soul searching, think about where your skillset is, think about your personality, and think about what you want to get out of trading.   If what you really want is the excitement and thrill of action-packed trading, then maybe discretionary trading is for you.  If you want to trade like a robot, then maybe strictly mechanical trading is for you.  If you’re like most traders, you’ll fall somewhere between, very carefully deciding what aspects of your trading should be mechanical, and where to allow yourself some discretion.

Hope this helps.

Happy Trading!

–  Andy


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