The Mechanical Trader is intended as a introduction to system trading, specifically within the context of the US stock market. Beginner and intermediate traders, as well as buy-and-hold investors, will hopefully find value in the concepts presented here. Advanced traders and money managers may also find the odd nugget that could further enhance their trading plan.
Mechanical trading implies the systematic use of a set of pre-determined rules to signal entries, exits, stops and position size. This systematic approach allows the system to be traded dispassionately, thus removing much of the anxiety associated with trading.
The antonym of mechanical trading is “discretionary” trading. Here the person relies primarily on intuition, using his gut and experience to predict market direction. Speculating without a plan is exciting, just like placing a bet at the roulette table of a casino. This is how most independent traders start, and how many blow up their first accounts. Those who survive soon learn that mechanizing both the strategy development and the trading process is the only way to achieve long term success and contain the stress inherent to this line of business.
A systematic approach to trading involves:
a) Using a data-driven development process: analysis, hypothesis, prototype, evaluation, strategy
b) Adhering to a clear set of operational procedures and a system maintenance plan
A systematic and statistically sound development process is important as it allows market theories to be tested and evaluated objectively. This scientific approach has the benefit of giving the trader real confidence in the resulting strategy, allowing him to trade it consistently once deployed. Modern computers, sophisticated trading platforms and access to historical data make it easy to test and evaluate strategies across different time periods and financial instruments.
A set of operational procedures is essential to ensure that the strategy is implemented consistently and systematically. A deviation from the plan – trade not taken, target price modified, etc – will negate the efforts made in developing the strategy and ultimately undermine the trader’s confidence in the system.
Mechanical trading and automated trading are not the same thing. Most mechanical systems, however sophisticated, require some degree of human intervention (placing orders, moving stops, etc). Fully automated systems, on the other hand, need only basic supervision. They essentially run like a plane on autopilot, with the machine executing orders automatically based on a strict set of pre-determined rules.
Mechanical or system trading often gets bad press because people associate it with high-frequency trading. And yes, high-frequency trading is indeed a form of system trading, but so are the majority of process-driven techniques used by traders and investors alike.
A systematic approach is undoubtedly useful to both short-term traders and long-term investors. The strategies and time horizons may be very different, but the same structured approach to system development, evaluation and implementation will be helpful irrespective of the strategy’s timeframe.
It takes a tremendous amount of time and dedication to develop a portfolio of profitable strategies. The bulk of the information available in trading books and professional journals, at seminars or on internet sites, is often misleading and sometimes downright dishonest. While there are some notable exceptions, finding quality “edges” in this sea of (mis)information is not an easy task.
Independent research is the only reliable way to generate actionable trading edges. The R&D work and computer programming involved can be tedious, and there are a lot of dead ends and red herrings. Moreover, one needs to be trained or self-taught in statistics to understand the finer details of a strategy performance report and be able to recognize a true edge from a statistical outlier. The process can be arduous, but there is huge satisfaction in creating a profitable strategy from start to finish. Being intimately familiar with the development process also elevates one’s belief in the strategy’s continued performance going forward, allowing one to trade it confidently once deployed.
The terms strategy and system are often used interchangeably, but a trading strategy represent just one of the many components of a trading system. A comprehensive system is usually made up of several distinct strategies each contributing to the profitability of the whole. Other components include position-sizing rules, risk-management rules and maintenance routines, all essential for the smooth running of the trading system.
The objective of this site is to:
Discuss timeframes, market and instrument selection
Page : Getting Started
Review the merits of different types of market analysis
Page : Market Analysis
Examine the areas that are likely to generate trading edges
Page : Identifying Market Anomalies
Discuss the systematic strategy lifecycle
Page : Strategy Lifecycle
Review the development of a trading hypothesis and prototype
Page : Hypothesis and Prototype
Provide an introduction to strategy development and evaluation
Page : Development and Evaluation
Discuss the challenges inherent to deploying and maintaining a trading strategy
Page : Deployment and Maintenance
Discuss the creation of a comprehensive trading system
Page : Developing a Multi-Strategy System