There are two approaches to trading: discretionary and systematic.
The former relies on the trader’s judgement to make decisions, whilst systematic follows a set of predefined rules.
Both of these have merits and drawbacks, and it’s not untypical for traders to look down upon the other group as inferior. Which, given we’ve had the budget and the US election, is probably something you’re no stranger to having seen.
I’ve seen how each style can affect a trader’s personality and P&L having worked with many traders, and I can say that there is no style that is objectively better. Only what is objectively best for you.
What is discretionary trading?
Discretionary trading is a method where the trader makes decisions in real-time, based on their market observations, analysis, and experience. Basically, the trader is sat in the driver’s seat ready to make decisions at any point and decide when to buy, sell, or hold based on their interpretation of the market conditions.
Advantages of discretionary trading
There are clearly some advantages here. It allows traders to adapt to changing market conditions. In times of high volatility or big macro events, discretionary traders can pull out of the market quickly or step it up rapidly should they choose.
It also leverages a trader’s experience and intuition. Obviously, a green trader at the beginning of their career is probably not going to be the best discretionary trader.
But the opposite is also true. Being able to withdraw from the market at any point may mean a trader overrides their systematic stop losses and rules, thinking that they are getting out of a falling market faster, only to find that the market rebounds without hitting their stop losses and carries on without them in the position.
If we think back to the ‘yen carry trade’ scenario in August, the market had a sharp fall, then rebounded immediately. Many people who got out quickly were relieved of their positions and missed out on the rebound.
But trading is ultimately a pattern recognition game, and for the experienced trader, this can bring about asymmetric trades that may not appear on a systematic system.
For example, a stock where the price is starting to creep higher yet the market has written the stock off due to profit warnings and disappointments and so little upside is priced in. This can offer a highly attractive risk/reward.
Discretionary trading also allows for creativity. For example, many years ago I once had a 15-second auto refresh following an anonymous bulletin board user’s activity on the boards. Wherever he would pop up (until he was banned) the stock would rally sharply.
No trading book will ever tell you to speculate on a random bulletin board account and try to front-run flow. Yet it was a highly profitable strategy for several weeks whilst his followers were jumping into every stock the account appeared at. And it worked until it didn’t.
Downsides of discretionary trading
The downsides of discretionary trading are clear.
It’s reliant on human decision-making, which is prone to emotions like fear, greed, and overconfidence. Keeping these emotions in check requires strict discipline, and studies have shown that we are influenced by things we see, hear, and do, in our everyday lives. Even our thoughts and beliefs can affect our actions.
These effects have been studied extensively in Thinking, Fast and Slow, by Daniel Kahneman. It’s a book I recommend reading.
Furthermore, these effects have offered inconsistent results.
Waking up feeling sluggish after a bad night of sleep will mean you’re more risk-averse and less likely to trade. Sometimes sitting a session out is a great idea if you think you’re not able to perform at your best. But if one of your A+ trades is set up for you, then not taking the trade, even in a reduced size, is going to mean you could miss out on a great session.
Another downside of discretionary is that it is incredibly time-intensive. Intraday trading, or day trading, is the hardest money you’ll ever make (and I’ve worked at McDonald’s).
Depending on what you’re trading, you need to be aware of the state of the market, the nuances in RNSs for specific stocks, and search for other factors that can affect the price.
But for those who can trade discretionary, there can be some huge asymmetric risk/reward opportunities out there.
What is systematic trading?
Systematic trading is trading to a system also known as “rule-based” trading. It relies on a set of predefined rules to generate buy or sell signals. These rules can be based on technical indicators, statistical patterns, or other objective criteria. With systematic trading, the room for subjective decision-making is reduced and instead, the system dictates the trades.
It would be easy to fall into the trap of believing that this is just a plug-and-play system that you can set and forget, but sadly that is not the case. However, it does remove much of the uncertainty and stress as you’re following a system that you can backtest and believe in.
The advantages of systematic trading
The advantages of systematic trading are clear. It removes emotional influence and the impact of emotions. It also helps new traders get on board and start to trade the market building consistency and discipline. Over time, this consistency can result in more reliable performance metrics and a better understanding of risk and return.
And because there are set rules, you can look back at historical data and see how the system would perform in various markets.
For example, I can look at using SharePad’s charts and see how trading stage 2 bases would’ve performed coming out of the Great Financial Crisis (the answer is very well).
It can also show you potential areas to optimise, improve, and put your own mark on a system.
Finally, the advantage of a structured system is that it’s easier to scale because it’s more predictable, and following rules will give you more trustworthy results.
Downsides of systematic trading
Systematic trading can sometimes lack flexibility to respond to sudden market shifts. Referring back to the yen carry trade though, sometimes having the flexibility to respond is not always a good thing.
During Covid, overriding your stops, getting out of the market, and hitting bids short worked incredibly well.
But nothing works all of the time, and so whilst it’s a downside, it’s not always a downside.
Another downside of systematic trading is that anyone building a system on historical data may find that if they torture the data enough, they’ll find a system that works perfectly… in the past.
But when applied to new market conditions this may not work perfectly. Adding 20 indicators and the stars aligning when Jupiter crosses Saturn is a lot more complex than picking simple indicators and trends.
For example, I only use daily candlesticks, volume, and moving averages on my chart.
And if a system isn’t performing well, there is always the temptation to move onto a shiny new object…
My view on discretionary and systematic
For new traders I believe systematic is best. Consider this as training wheels in order to start learning the ropes, understanding why things are happening as they are, and why you want to see this.
For example, I like stage 2 uptrends because momentum is in my favour, and there is a clear uptrend in the shares. I’m not gambling on the bottom like I would be if I picked a stock that was downtrending.
I have clear entry signals, for example, gap-ups on surprise good news, and breakouts from long, extended bases.
I have sell signals too for when trends start to break down or there is surprise bad news.
But time in the market brings experience, and you may start to see patterns where you believe the risk/reward is handsomely in your favour.
My suggestion is to always log what you’re doing in a trade journal. This is because you need to see if your discretionary trades are working.
Let’s say your system is working in the long run, but 20 discretionary trades have left you down 10R overall, then it’s clear something may be wrong.
Are you nailing your entries? Getting slipped on stops? Was your idea even a good one?
Only with data can you know.
Which is best? Discretionary or systematic?
I don’t believe there is a ‘best’ although systematic is definitely better for beginners.
You also mix both by using a systematic strategy to generate ideas and then apply discretionary decision-making to entering and exiting. Or you follow a system and allow discretionary interventions in times of volatility.
I’ll be running a live cohort program starting the 26th of November. I’ve created a short survey that will help me learn what you need to succeed and this will get you on the Priority List. This means you’ll get first access before everyone else.
Michael Taylor
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