Discretionary versus mechanical systems, how are they different? In forex, we classify traders as either using discretionary or mechanical strategies.
Before the days of advanced trading platforms, traders made their trading decisions purely from studying the charts. This process was a time-consuming endeavor, involving some effort observing and mapping out specific patterns in the markets.
Thanks to the advancement of trading software, a new class of traders began emerging who automated the process through their programming skills, giving birth to what we now know as robots or expert advisors (EAs).
Currently, we class trading strategies or systems as either mechanical or discretionary. But what exactly are the differences between the two, and is there one objectively better than the other? Let’s find out.
What is a discretionary system?
As the word suggests, a discretionary system is a methodology relying primarily on discretion instead of an automated approach. Traders rely on well-known techniques or strategies such as chart patterns, support and resistance, supply and demand, price action, a combination of all four, and so on.
While a discretionary trader also has rules set in stone before making trading decisions, they have more flexibility for alteration because of gut feel and intuition. Such characteristics come with years of experience and screen time by seeing many different scenarios in real-time.
A discretionary trader sees themselves as a better discerner at predicting price movements than a computer. It’s often expressed that market psychology, or collective behavior, is the primary driving force for trends.
Understanding how a mass of people behave at certain points is something a discretionary approach aims to achieve by using patterns, indicators, and other analytical tools. Most traders nowadays arguably are largely discretionary.
Even with a trading plan, traders can still override any action because they have an ultimate say on buying or selling.
What is a mechanical system?
A mechanical system (sometimes referred to as a rule-based or algorithmic system) refers to an automated method of trading a financial instrument. In the context of foreign exchange, the prime example is an expert advisor or trading robot popularized by MetaTrader 4 in the mid to late 2000s.
Using a mechanical system involves some adequate knowledge of a programming language within a charting platform such as MetaTrader and the like. Based on a profitable strategy, trader programs all the necessary parameters of entry, stop loss, exit, and position sizing autonomously with no manual intervention.
Essentially, a mechanical system is simply ‘plug and play.’ and works around the clock with a constantly functioning internet connection.
Pros and cons of a discretionary system
The biggest advantage of a discretionary approach is traders tend to have more control over the execution. Through experience, one is highly adaptive to different market conditions to adjust their decision-making process accordingly.
One of the criticisms of mechanical-based approaches is their inflexibility towards varying market environments. For instance, while such a system can work perfectly during normal periods, it rarely will bypass an erratic high-impact news event.
A discretionary trader can easily witness the volatility of such an occurrence and either stay away entirely or wait for things to simmer down. On the flip side, the biggest disapproval for discretionary guys is human error.
Even if someone is following what they consider a bulletproof trading plan, the possibilities for missing some criteria in the decision-making process are always imminent. Discretionary traders need to maintain flawless execution consistently.
The second challenge is analysis paralysis can still occur even with a set of defined rules. Lastly, discretionary approaches can fall victim to hindsight bias where traders regret a trade they would have taken.
It’s difficult for the average person to have honesty over whether they would have considered entering a position that ended up being profitable. Overall, discretionary methods come with a lot of subjectivity and room for varying interpretations.
Pros and cons of a mechanical system
On the pro side, mechanical systems enhance the execution that may take a little longer if one executes their positions manually. This advantage matters especially for scalpers, day traders, or other short-term strategies where every second count, considering the rapid, fluctuating nature of price and variable spreads.
A trader ultimately minimizes the physical and mundane tasks of execution by using a mechanical methodology since everything is already pre-programmed.
Lastly, mechanical systems are known to remove the emotional side of trading since they follow an absolute set of rules with no deviation and room for subjective perception.
For disadvantages, mechanical systems are often slow or don’t adapt to the ever-changing market conditions, which is perhaps the most significant detriment. At this point, only artificial intelligence in the future could have the capability of perfect human discernment.
Mechanical systems typically also don’t allow for dynamic position sizing, entry and exit parameters. Discretionary traders understand every trade is independent and can adjust all these metrics suitably. For instance, one position may logically require a 1:5 risk to reward ratio while another 1:3.
Therefore, someone can adjust their stop loss from, let’s say, 50 pips to 25 pips, and alter their position size accordingly. In most cases, mechanical systems don’t have this flexibility. Often, many of these will use one collection of risk parameters regardless of the position being taken.
Overall, there are limits to quantifying gut feel and intuition mechanically.
Final word
Ultimately, a discretionary method sees a human controlling every aspect of the trading process, while a mechanical method utilizes computers and algorithms. The industry is filled with people selling robots to uninformed traders, which experts mainly consider ‘black box systems.’
By black box, an expert advisor contains many hard-to-understand internal workings. They are often erroneously advertised as a quick fix and a guaranteed way to make money, but only a few can truly stand the test of time.
However, there objectively is no one universal way to trade between discretionary and mechanical. Like anything in trading, it boils down to many things. Both approaches can work wonderfully with the right combination of preference, experience, and knowledge.
