Mechanical Trading Strategies Vs. Discretionary Trading Strategies – Pros and Cons
Mechanical Trading Strategies Vs. Discretionary Trading Strategies
When it comes to trading, you are either using mechanical trading strategies or trading at your discretion. What is the difference, and which is better? Let’s find out.
Mechanical trading strategies refer to automated trading using trading algorithms with pre-set instructions. The primary purpose is to remove as much human emotional behavior as possible from the trading process. Discretionary trading, on the other hand, is decision-based trading — the trader decides which trades to make based on current market conditions.
Let’s go a bit deeper to understand the differences between the two approaches.
What are mechanical trading strategies?
Mechanical trading strategies are any of the different methods of automating trading using pre-set criteria or triggers. The primary purpose of this approach is to remove as much human emotional behavior as possible from the trading decision-making process.
As you know, trading involves making many decisions: when to buy, when to sell, when to realize a profit, when to take a loss, etc. All those decisions can be tiresome and sometimes very difficult to execute or even prone to emotional mishaps; with mechanical trading, the rules are preset and coded into a trading algorithm that executes the trades without emotions.
A mechanical trading strategy can take any form — from as simple as automatically moving a specified dollar amount or paycheck percentage into a 401(k) account each month to strategies that are based on valuation markers like price-to-earnings ratio or technical indicators, such as moving averages, (simple or exponential), RSI, MACD, stochastic, and so on. Whatever the level of sophistication, mechanical trading minimizes the effects of emotions in trading.
Essentially, the benefits of mechanical trading systems can be summarized into the following points: automation, consistency, saving time, probability-thinking, exploiting the law of large numbers, and creativity.
What are discretionary trading strategies?
These are decision-based trading methods — the trader decides which trades to take based on current market conditions and the information available at the time. The decisions are made based on the trader’s personality and how they feel about the market. This type of trading is what most traders do.
Although discretionary traders use their discretion in taking the trade and managing it, they still have to follow a trading plan with clearly defined trading rules.
However, they can bend their rules when they think the conditions are different. For instance, they can increase their profit targets and stop loss if there’s high volatility and reduce those parameters or even suspend trading when there is low volatility. Also, if a trader knows that their strategy tends to perform poorly during certain market conditions, they will avoid trading during those times, and if they notice their strategy tends to perform very well in other conditions, they can increase their position size slightly during those times to maximize gains.
While some traders may figure out how to get in tune with the market, many other traders don’t get to achieve that and end up trading emotionally. Many traders are prone to second-guessing themselves and are poor at deciding when to trade and when not to. By its nature, the discretionary trading approach is susceptible to the trader’s psychology. For example, no matter how profitable a discretionary trading strategy is, being too greedy or fearful can destroy the profitability of that trading system in a hurry.