System-Based vs. Discretionary Trading

There is a certain appeal to developing an automated trading system that requires you to act in a specific way every time market movement sets off a signal. The upside is that, for some traders, it is far easier to maintain a discipline about their trading when there is no discretion in the decision-making process. The downside is that In order to derive the full benefits of a profitable system, the trader must carry out the system’s instructions to the letter. 

Developing trading systems, however, is a major undertaking. While some traders are able to use off-the-shelf software programs to back-test historical data, many run into problems. What’s more, everyone seems to be searching for the Holy Grail of trading systems—one so powerful that it is 100% foolproof and yet so secret that it has not been discovered. (Good luck with that!)

Another problem with developing a trading system is that the available market data is often corrupted with inaccuracies.  Finally, and most significant of all, is that many developers tend to optimize their systems to the point where they are of no predictive value. Optimization occurs when the developer knowingly or unknowingly “fits” the market data to support a particular conclusion. 

Being a discretionary trader is no walk in the park either. Discretionary traders have rules to follow, just like their programmer counterparts. The distinction is that discretionary traders apply those rules based on their subjective understanding of each situation. From one trade to the next, there may be significant differences in how the trader’s strategy is implemented. This is not to imply that a discretionary trader can get away with lapses in discipline. Rather, it is because the trader’s decision-making process is subjective that discipline must be in the forefront at all times.