System Trading vs. Discretionary Trading:
Which Is Better? Part 1

Trading Places

Dan Akroyd and Eddie Murphy , as they prepare to enter the trading pits:

Louis Winthorpe III: Think big, think positive, never show any sign of weakness. Buy low, sell high. Fear? That's the other guy's problem. Nothing you have ever experienced will prepare you for the unlimited carnage you are about to witness. Superbowl, World Series - they don't know what pressure is. In this building, it's either kill or be killed. You make no friends in the pits and you take no prisoners. One moment you're up half a mil in soybeans and the next, boom, your kids don't go to college and they've repossessed your Bentley. Are you with me?

Billy Ray Valentine: Yeah, we got to kill the mother f****r - we got to kill 'em!
--from "Trading Places"
Just as Randolph and Mortimer Duke explored the endless debate of environment versus heredity in the movie Trading Places , over the next two weeks we'll dive into the debate of systematic trading versus discretionary trading .

The Debate
Systematic trading has been around for decades. Yet, up until a few years ago, it was viewed suspiciously by most of Wall Street. The overwhelming feeling was that no system could ever do better than a team of well-trained individuals who, with proper risk controls, could find the best opportunities to trade each day.

But, over the past few years, there has been a concentrated movement by many firms to hire "quants" who rely upon statistics to help make trading decisions. Many of these quants graduate from top schools (we have one on our staff...MIT) and many have advanced degrees in physics, mathematics and computer science. Many of the firms who rely upon a systematic way to trade will tell you that it's the only way to go. On the other side of the coin, there are many, many firms (and many great traders) who will tell you that they've always made their money using discretion and they will always trade this way. So, who's right?

Let's Look For The Answer...

I suspect that this question has entered your mind as it pertains to your own trading. Should you trade systematically, or are you better off using your own experience and intuition? Before we get to the answer, let's look at the pros and cons of each. This week, we'll look at systematic trading and next week we'll look at discretionary trading. And from there, you'll be able to make educated decisions for your own trading

Systematic Trading

First , I'll tell you that over the past few years I've slowly but surely evolved into a systematic trader. But, as you will see, I'm going to be brutally honest about the strengths and weaknesses of each approach.

Let's define what systematic trading is. It's trading with an exact set of rules . These rules are so tight, that a 15-year-old can execute the trades for you. When the system says "buy," you buy. When it says "sell," you sell. No questions asked. No discretion ever taken...period!

Let's begin with the negative side. First and foremost is: how well tested is the system ? Questions must immediately arise as to how far the look- back period was for the testing. Does the look-back period include both bull and bear markets? Does it go back at least 7-15 years, or is the period much shorter? Were the returns of the system distributed equally over the period tested, or did they mostly occur in one or two years? How many rules does the system have? (the more, the worse. I've seen systems that have pages of code...uugghh!!!) The list can go on and on and many systems fails because they are deficient in one way or another.
In my opinion, the best systems have many years of data and are combined with few rules (your motto should be "a few rules are good -- fewer better."). And these rules must make market sense. Maybe someone can show a system that has been correct 100% of the time when buying the S&Ps the day following a game that Roger Clemens pitched and won. Wouldn't that be great? 100% correct! It has hypothetically never been wrong in a decade. One rule. More than 15 years of data. But it makes absolutely no sense. It's just like the Super Bowl System...it's nonsense, yet it gets quoted every year by the geniuses in the financial media. So, the biggest detriment to trading any system is whether or not it's valid and whether its rules have integrity.

Now, let's assume it is a valid system and all the above stipulations have been met. The next question becomes: what happens if the system stops working? Worse, how do you even know it has stopped working? It may have 4, 5 or even 10 losses in a row. But, for many, many good systems, this will happen from time to time. At what level of losses does it make sense to drop the system? It's a very, very tough question, and one that is dealt with all the time by systematic traders.

Let me give you an example. There is a very well known trend-following system used by many money managers (CTA's), including the original Turtles group. The system basically trades a basket of commodities (rarely stocks) and uses a 20-day high to enter and a 7-day low to exit (shorts use a 20-day low and a 7-day high as the exit). From there, it goes deeper as money management, pyramiding, and portfolio management take over. Some of the biggest names in the business use variations of this method, including John Henry , the owner of the Boston Red Sox. Henry has had two decades of success systematically trading his money and others' money with this approach. So much success that he can afford to own a baseball team. But, look at his funds' track record this year. Through July 31, six of his funds are down more than 20% . Two are down over 30%! His biggest fund is down over 24% over the past 12 months (this data can be found at www.iasg.com ). Not only does he run the risk of owning a baseball team which won't make the playoffs, along with facing the prospect that the hated Yankees may field a team next year that includes Nomar Garciapara at 2nd and Pedro Martinez on the mound (yes, Steinbrenner is that sadistic), but he also has massive drawdowns occurring in his funds using a system that has worked for many, many years.

Does this system no longer work? I suspect it still does work, but these drawdowns are amongst the biggest he has seen. And, many other big name money mangers with long, successful long-term track records using this approach are seeing losses of the same magnitude (see Dunn Capital as another example). And, as with any system, no one will know if this methodology is dead until after it's dead. And by then, it's obviously many years too late.

So the question that Henry, Dunn and the other trend followers now face (and have faced in the past) is: does their system still work ? Do they change to a new system or do they continue using their current system? Millions and potentially hundreds of millions of dollars of fees are at stake. And, even though I have no idea what they are thinking, it must be very painful to live through these losses. And these people face business decisions that are critically important to their business' long-term success.

The next thing to consider when deciding to trade the system is: do you have the intestinal fortitude to sustain the drawdowns and losses that every system has and not jump to a new system ? The human urge is to walk away from a system with a few losses and move into a system that has had recent gains. But, many times, the best time to trade a valid system is after it has had losses. And the worst time to start trading a system is after it's had many winning trades. Few people can do this. They leave the system after its had a handful of losses, or worse, they start trading more aggressively AFTER the system had a string of winning trades. This usually occurs right before the law of averages kicks in and some losing trades occur.
Going further, what about tweaking the system ? This means making small changes along the way even though the system has historically been a winning one. That's another urge that most traders have to deal with, especially during drawdowns.

Another pitfall of systematic trading is that it's boring . There's little intellectual stimulation from it. All the thinking has already been done and placed into the system. And for many people, part of the love of trading is not only making money, it's also the challenge. And there is little challenge when your only job is to execute trades when a signal triggers.

I've listed only a few potential pitfalls to systematic trading, and there are many more. But -- as you will learn next week -- there are just as many drawbacks when it comes to discretionary trading.
Five Benefits Of Systematic Trading

1. If the back-testing for the system is solid, not optimized and done correctly, one has the peace of mind of knowing that the setups being used have made money in the past. And even though there is no assurance they'll continue to perform in the future, should the system perform in-line as it has for many years past, the user of the methodology is likely to be very, very pleased over time.

2. It is quantifiable . It is impossible to quantify discretionary trading. Different people looking at the exact same thing will nearly always interpret what they see differently. Systematic trading has no fuzzy rules- it's always black and white. At all times you have clarity


3. Systematic trading takes much of the gut wrenching, up and down emotion out of trading. There's nothing to think about during the day. You simply take the signals. If you don't, you're not only a discretionary trader, you're bringing the chaos back in which always leads to the emotional roller coaster most discretionary traders experience.

4. Further to number three. The noise created by the media and Wall Street analysts is eliminated . Their "un-quantified guessing" officially becomes irrelevant. All of us are swayed one way or another in our thinking by these people. But, not the system. The system has no mind. It simply triggers the signal and the trade is taken.

5. If the system continues to work, you're freed up to do other things. You can spend time enjoying other things in life (like watching Trading Places for the 943rd time) and/or you can even spend time thinking of additional ways to make money. You don't have to be glued to the screen all day. For some people, this doesn't matter. For many others, it's a big plus.

No guessing, little emotion, and more free time are the benefits of systematic trading. And the biggest benefit is that if the system continues to perform, you'll very likely make good money for quite some time.

Next week we'll look at the pros and cons of discretionary trading. And from there, we'll put the entire picture together to help you decide what's the best route for you to take.

Have a great week trading (and if you have any questions or comments, please email them to me at lconnors@tradingmarkets.com )!
Larry Connors

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