System Trading vs. Discretionary Trading: Which Is Better? Part 2

In part one, we discussed the pros and cons of using a systematic approach to trading. In part two, let's look at the same for discretionary trading .

What Is Discretionary Trading?

Discretionary trading is when a trade is taken where a decision has to be made on entry, exit, and position size. It can be just one of these or it can be all. Most of the trades made on Wall Street are made with some type of discretion. Yes, many money managers and traders use a specific methodology (think of value investors who buy low p/e stocks as an example), but in one manner or another, there's an element of discretion taken. This discretion could be an element of timing (or lack of timing), intuition, analysts' opinions or more that in some way or another makes the methodology non-systematic. Again, if a 15-year-old can't "exactly" trade the rules, then discretion is likely involved in making the trade.

Let's Look At The Negatives To This Approach

Just as there are negatives to systematic trading, there are negatives to discretionary trading. Here are a few:

1. Can't quantify : You never exactly know what you have. You can't quantify the perceived edge until many years after you've traded in the manner you've traded (there's also no exact formula to test and look back on).

2. A reason to lessen your visits to Starbucks : More to number 1. This is reality. After the results are created in real time, one really doesn't have a clue as to exactly how they got there. Why? Because discretion was taken. And there's usually little consistency to discretion. If one is relying upon their gut, they can in no way know if that same intuition will achieve equal returns over time.

This can get a bit complicated, so I'm going to give an example: imagine the market has opened five minutes ago. You have a healthy position in a stock and the stock has quickly moved against you and you have a loss. You have a decision to make. Do you take the loss? Do you exit a piece of your position and hold the rest? If you decide to exit a piece, what percent of that piece do you exit? Do you not exit at all? Or do you add to the position because the market dynamics are beginning to turn in your favor? Real-world situation, it happens every day and how you react will determine your P&L for the day and for the year (as every decision you make will). Systematic traders have all this figured out. Discretionary traders usually don't.

Now, let's go a step further. Obviously this trader is under a stressful situation and his decision-making process is going to be challenged here. Will his/her decision-making process be different if they just had a cup of coffee 20 minutes earlier versus not having any coffee? Of course it will. Now go further -- what happens if they decide to have a second, third and fourth cup of coffee? Will their decision-making process remain the same? (of course not). What happens if they slept poorly the night before, or got in an argument with their spouse, or have a child that's ill, or they are just simply having a bad day? Go the other way, what if they had a great trading day the day before? Will their decision-making process be the same versus a day following a bad trading day? I can give you hundreds of tiny, incidental events (drinking a cup of coffee is certainly incidental, yet it affects performance both good and bad) and once you start realizing this, you realize that there is an enormous amount of potential chaos in every single trading day. If this same market scenario happens 20 times a year, I will guarantee you will have 20 different results because of the outside forces, many of which can't be controlled. And you'll have no idea why the trading results occurred as they did (one will blame/praise the methodology, curse the market, etc. when in fact in many cases the methodology was fine/bad, it was chaos involved that created the returns (or lack of returns).

3. More structure is nearly always better than less structure . This is true in sports, trading and anything else in life. Take two shortstops of equal abilities at age 12. Over the next year, one takes 250 well-placed, hard-hit ground balls every day under the supervision of a good coach. The other decides he wants to improve also but he's allowed to do whatever he wants to do. Who is going to be the better player in a year? Nearly every time if you had your choice of kids to play for you, you'd take the kid who was structured and had a proven plan to get better. It's the same with trading. Take the structured plan, or take the chaos?

I could go on here but remember from last week, their are also many negative aspects to systematic trading.

Why Discretion Can Be Good

1. Because for many people, it works . And after writing the above, the following words say a lot. I personally know, and have seen the statements, of many profitable discretionary traders. In fact, the other day Don Miller sent me his statements for the year. Profitable...very profitable. And even though he's structured in his trading, he does use an element of discretion . And I can give you a list of other names of profitable discretionary traders if you want. The fact that many of these guys exist says a great deal.

2. I have seen discretionary traders make my own research better . Paul Taglia sees high-probability Window set-ups that the rest of us don't. I've seen him do this for nearly two years. He can't explain it...he simply says that he's looked at thousands and thousands of charts over his career and some charts simply look better to him than others. We once asked him to keep a journal to see if we could systematize what he saw. It was a useless exercise. He sees it but he can't explain it. It's his experience. And most successful seasoned traders will tell you that intuition is simply a culmination of one's experience.

3. The ability to change course : When very obvious market opportunities arise, discretionary traders can grab them. The more disciplined systematic traders may be tempted but they won't go there (and they shouldn't). But there are a few times in every year where there is money on the table to be taken. And the better discretionary traders will be there to capture theses opportunities.

4. Whereas systematic trading is boring (very boring), discretionary trading can be very interesting . It's mentally challenging. And trying to figure the market out can be a fulfilling lifelong pursuit. As I said last week, for some people this means little; for others, this means a great deal.

Wrapping It Up

So there you have it. Two weeks of columns laying out some of the bigger pros and cons of systematic and discretionary trading. Which is better? Which is correct for you? Only you can answer that. Both have negatives, both have positives, but most importantly, both have many money managers and professional traders who have made healthy amounts of money using each approach.

Larry Connors

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