Automated versus discretionary
The Discretionary trader
People always get into the Forex market and start trading with no system at all. They approach the markets applying their beliefs that were working fine for them in their normal life. That, also, includes all their personal biases. Biases which happen to be rather harmless in normal life but a ticket to disaster in the forex markets.
When trading solely on beliefs, greed, fear, and stress poison the trader’s thinking process. The consequence of these emotions mining their reasoning is twofold.
If the trade starts to be favourable, their fear of losing urges them to close the trade too soon, cutting winners short, if the trade goes against them they wait too long in the hope that the price moves back to winning level, letting losses run. That, in combination with leverage, is usually a recipe for disaster.
Also, the discretionary nature of this type of trading makes its results very similar to the ones obtained using a system with random entries and exits. However, with the already said handicap of the trader cutting gainers and letting losses run.
The Automated System
Opposite to discretionary, an automated trading system has a rigid set of rules. Entries stops and exits are defined following perfectly clear conditions. That way we take away all the emotional content.
When designing this kind of trading systems, people use rational thinking, away from the emotional nature of the market. Designers backtest the system using large historical databases. Systems that pass the quality filter have a higher likelihood that they continue performing well in the real markets. The cybernetic discipline when applying it live, allows the trader to compare its intended statistical parameters against reality, and will enable him to recognise when it starts underperforming. When it needs some tweaking due to a shift in market volatility or other conditions.
Splitting of the trading task
Discretionary traders should consider approaching the market acting as much as possible as an automated system. Therefore, they should use strict rules, on entries, stops and exits. Further, to avoid being driven by the emotional thinking they should, also, split the Trading Task into two parts: The Planning Task and the Execution Task.
During the Planning Task, they should enforce a rational analysis on every trade. Therefore, entry, stop and exits should be set during this stage. The Execution Task must be performed using strict discipline and no second guessings, following the plan devised when the rational mind was in control. That way the emotional mind is kept under the control of the rational brain.
Writing down a record of the trade before its execution, or immediately after the entry stage, is good to help the rational mind take control.
The Underlying Factors
Economic information has a gradual effect on the price movement. New information is not immediately discounted. That is the basis of trend developments. This information affects the equilibrium of supply and demand, but, since the market has incomplete knowledge about the new fair value of the asset, it has to discover it through price action.
Leverage creates volatility in the markets because no trader has the unlimited means to hold onto a losing trade forever. That creates waves of buying and selling and is the reason the distribution of market returns shows fat-tail probabilistic density functions.
Leverage trading is the cause, also, of the segmentation of the market participants by their capability to take risks, which, in turn, creates another division by objectives and time frames.
The market reacts to new trading methods. A system produces declining returns as its popularity grows among market participants.
Retail trader’s success rate is below 10%. Brokerages know that very well. Their client base turnover is exceptionally high. Also, the new wave of traders seldom learn the lessons from the last wave of losers. Therefore, the market forgets long-term and old patterns come back.
There is no short-term link between the fair value of a security and its price.
The random walk of the markets
The combined action of the said processes is accountable for the chaotic nature of the price action.
That is the way it should be. A market would not be possible if all market participants had the same opinion, timeframe and objectives. However, the result of millions of participants, trading in different circumstances and goals is that the price movement is as noisy as a random process.
That can be observed in Graph 1. The image renders the equity progression resulting from three different games, each one of 300 coin-flip bets. The astute observer can see the close resemblance to the ups and downs of a currency pair.
Graph 1- Random walks of three coin-flip games (click on it to enlarge)
Antagonistic strategies may both succeed or fail.
Since a market works when different strategies meet, it may happen that, long term, traders using opposite tactics both made money.
One known example is the Turtle System, a long-term trend-following system. With the spread of success of Turtles, the market reacted bringing up a short-term counter-trending system called The Turtle Soup. Both groups of traders made money, although the second group profited from the first one, and reduced their returns.
On the fail camp, if the backtesting of a strategy is a complete failure, it’s unlikely that reversing the trade signals would convert it into a success.
Back to Freedom
The Forex market is an open environment where a trader is free to choose entry point, direction, size and, finally, exit time and target. Such freedom to act is a burden to discretionary traders, as we already have said.
There are two primary biases a trader suffers The need to be right and the assumption of general properties of a system with just a few samples.
These two prejudices combined are the driving forces behind the trader’s preference to cut profits and let losses grow.
The need to be right is the culprit for the trader’s bent for systems portraying high winner per cent trades instead of high-expectancy systems.
Therefore, a systematic approach, using strict trading rules is the only method to increase the likelihood of success.
Professional Automated Trading, Eugene A. Durenard
Systematic Trading, Robert Carver
Profitability and Systematic Trading, Michael Harris
Computer Analysis of the Futures Markets, Charles LeBeau, George Lucas