Thursday, February 28, 2013

Automated Vs Discretionary Vs System Trading

In the world of trading, there are two main schools of thought- programmed/automated and discretionary methods of trading.

Discretionary trading is when one is making decisions on what to do real time based on market activity. Automated trading removes the human decision making element out of the process and does pre-programmed responses based on market activity.

For computer automated trading - ideally the biggest pro would be that you'd be able to turn it on and just sit back and let the cash roll in while it does its thing. No thinking required- just a simple flip of the switch to make money. No faulty human interaction to mess things up...

It's the Holy Grail that every trader has thought about at some point and would love to have- who wouldn't? cool

On the opposite end, you have discretionary trading, where people decide whether to buy or sell based on what they see going on in the market. This is what the majority of non professional retail traders do.
The region of space both types can share is systematic trading - where you trade according to a defined set of trading rules and methods. The automatic traders will have these rules programmed in while the discretionary trader manually operates his system. My trading style falls into the category of discretionary system trader.

Which method is better? People working on automated systems swear by them and condemn discretionary traders as giving their money away to the market. Discretionary traders scoff at automated traders as trying to perform an impossible task resulting in a big waste of time and money.
In the professional world of Wall Street, automated trading machines exist but they only look to make pennies per trade- the key for them is performing thousands of transactions per second so they can make big profits on mass volume. You need big bucks to have such a machine and a big outlay of capital to be able to afford to trade on such a large scale. In other words, this is not available to non professional private traders like myself that trade on a far smaller scale.
On the smaller scale,  an automated system would have to place fewer trades that would last longer. To date, while I have "heard" of automated systems that are successful for the retail trader, I have yet to see a bonafide proven system that one would say is successful if your goal is to keep risk low and live off the income.

The Kryptonite of discretionary traders are their emotions. The market is geared to induce an emotional response that will lead you to doing the opposite of the right things to do. One of the first things a competent trader has to master is the control of their emotions and ego- it's the cause for most discretionary trading losses.
Purely discretionary traders treat the market like an extension of a Vegas casino and make "bets" based on gut feelings. As you move towards more organization and control, you have "system" traders who have a defined method/strategy of making trades, but it's not automated and instead done manually.

This is the biggest "pro" of automated trading - removing the human chaotic human emotional factor from the equation.

However, as a discretionary system trader, my answer may be biased, but I think "organized/system" discretionary trading is superior to automated trading for the following reasons:

1) The market is comprised of living/thinking traders, which makes the market a living entity of sorts composed of the summation of human actions. Trying to code that type of random behavior analysis into a working program is incredibly challenging and perhaps beyond the scope of the technology that currently exists for it to perform consistently well for retail traders.
2) It's said that the market never repeats but often rhymes- making it difficult to program in those subtle variances.

3) The learned response: being able to learn/adapt from past mistakes favors discretionary over automated trading.

From the above, I think #3 is the biggest reason against automated system trading. When market conditions cause a trader to lose money, they know they need to make changes to their methods. A discretionary system trader likely has a better feel for the market than an automated trader who just plugs in market variables. As a result, the discretionary trader will have a better chance at pinpointing the exact problems while the automated trader only knows the current running programs need changing, but no specifics on which variables or rules to change.
Running automating trades comes at the price of not having a hands-on feel of the market, so detailed knowledge of market behavior and nuance is not as developed as those with their hands continually on the driving wheel such as discretionary traders are.
I can point to my own trading growth from being able to do analysis on my trading logic and figure out what improvements to make to adjust for the market.