- The Market
- Winning and Losing
- Investor v. Trader: How Do You See the World?
- Fundamental v. Technical: What Kind of Trader Are You?
- Discretionary v. Mechanical: How Do You Decide?
- Timeless
- Has Trend Following Changed?
- Trend Following Modus Operandi: Follow Price
- Follow the Trend
- Handling Losses
- Conclusion
- Key Points
This chapter is from the book
This chapter is from the book
This chapter is from the book
Discretionary v. Mechanical: How Do You Decide?
We have established the idea that you can be an investor or trader. We have established that trading can be fundamentally or technically based. Further, technical trading can be predictive or reactive. And we've explained how trend followers are traders who use a reactive technical approach based on price. However, there is one more distinction. Traders can be discretionary or mechanical.
It is when the unimaginable occurs that the systematic trader remains calm, presciently knowing when to buy, sell, or adjust their exposure.
Mark Abraham Quantitative Capital Management, L.P.
John W. Henry, one of the best trend followers over the last 20 years, thinks it's important for clients to know his approach and he makes a clear distinction between the two strategies: "JWH believes that an investment strategy can only be as successful as the discipline of the manager to adhere to the requirements in the face of market adversity. Unlike discretionary traders, whose decisions may be subject to behavioral biases, JWH practices a disciplined investment process."15
When Henry speaks of decisions that may be subject to behavioral biases, he is referring to the legions of traders who make their buy and sell decisions based on the sum of their market knowledge, their view of the current market environment, or any number of other factors. In other words, they use their discretion—hence the use of "discretionary" to describe their approach to trading.
Decisions made at the "discretion" of the trader are subjective and therefore can be changed or second-guessed. There are no ironclad assurances that these discretionary trading decisions are based on reality, and not colored by personal bias. Of course, a trader's initial choices to launch the system are discretionary. You must make discretionary decisions like choosing a system, selecting your portfolio, and determining a risk percentage. However, once you've decided on the basics, you can then choose to systematize these discretionary decisions and from that point on rely on a mechanical trading system.
Mechanical trading, used by trend followers, is based on an objective and automated set of rules. The rules are derived from their market view or philosophy. Traders rigidly follow these trading rules (often putting them into computer programs) to get themselves in and out of the market. A mechanical trading system makes life easier by working to eliminate emotion from trading decisions and forcing you stick to the rules. It enforces discipline. If you break your own rules with a mechanical trading system, you can go broke.
I feel sorry for the traders who watch CNBC all day, every day. They hope to eek out some competitive advantage from the comments of some guy who has never traded an S&P contract in his life. Even if the media happened to have something relevant to say, the news is already reflected in the open, high, low, close, open interest and daily volume.
Christian Baha CEO Superfund
John W. Henry speaks to the downsides of discretionary trading:
"Unlike discretionary traders, whose decisions may be subject to behavioral biases, JWH practices a disciplined investment process. By quantifying the circumstances under which key investment decisions are made, the JWH methodology offers investors a consistent approach to markets, unswayed by judgmental bias."16
It seems a bit rigid to say you can't even use just a little discretion when faced with a trading decision, doesn't it? After all, where's the "fun" if all you ever do is follow a mechanical model? But then Trend Following isn't about fun. It's about winning. The Director of Research of Campbell and Company, one of the oldest and most successful Trend Following firms, is adamant about avoiding discretion:
"One of our strengths is to follow our models and not use discretion. This rule is written in stone at Campbell."17
The trend is your friend except at the end when it bends.
Ed Seykota18
You will see that, like Campbell's Director of Research, trend followers use their words carefully and deliberately. It was encouraging to us to find that there are few if any instances when their words don't reflect their performance data.
A very private individual, with whom I am closely associated, has quietly turned $150,000 of his own capital into over $4.5 million trend following since 1997.
Tom Rollinger Altegris Investments