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Discretion and Systems Trading
Discretion within a Mechanical Framework
Contradiction is not a sign of falsity, nor the lack of contradiction a sign of truth.
The issue of discretion within the context of a mechanical trading system is always a controversial matter, because its inclusion could lead to a breakdown in trader discipline and consistency. During the developmental stages of this manuscript, I debated omitting the topic of trader discretion to prevent a discounting of my emphasis on consistency and discipline in trading. It is to prevent readers from discounting the importance of consistency and discipline in trading that I introduce the subject only after laying the groundwork in terms of the preeminent importance of maintaining a disciplined approach to execution of trading signals.
The marketâ€™s propensity to experience paradigms shifts and price shock events largely led me to decide to retain this chapter. Excluding the issue of trader discretion within the context of a mechanical trading system could lead readers to be unprepared and/or complacent. Although it may be true that adherence to the principles of sound money management (as outlined in Chapter 8) can allow systematic traders to avoid ruin during paradigm shifts and/or price shocks, this ability to â€śsurviveâ€ť is probably a suboptimal solution to the employment of mechanical trading systems.
DISCRETION AND PARADIGM SHIFTS
Although there is no objective answer to the question of what constitutes a paradigm shift in market dynamics, for the purposes of this book I will
MECHANICAL TRADING SYSTEMS
define the phenomenon as a permanent or long-term shift in market behavior that greatly diminishes the viability of historically robust trading models. In Chapter 7, I presented an example of a paradigm shift through the comparison of Figures 7.1 and 7.2, which illustrated a collapse in the performance of the 20-day channel breakout system for IGBPUSD (British pound-U.S. dollar) from 1993 to 2002 versus 1983 to 2002.
When faced with paradigm shifts, mechanically generated trading signals could (depending on the size of system stop-loss levels employed) result in the termination of a system traderâ€™s career. Recognition of the potential severity of this problem has led to the establishment of some possible thresholds for the introduction of a discretionary overlay to the implementation of mechanical trading systems.
Some of these potential thresholds are, in fact, objectively quantifiable (and therefore mechanical) and were alluded to in Chapter 8. They include exceeding the maximum number of consecutive losses experienced by the system during its backtested history and exceeding of the systemâ€™s worst peak-to-valley equity drawdown and stop-loss levels for trading systems. In such instances, a prudent discretionary course of action probably would entail suspending execution of signals generated by the trading system, or, at the very least, reducing volumetric exposure to the floundering system (until the market dynamics in question reasserted themselves).
DISCRETION, VOLATILITY, AND PRICE SHOCKS
Just as there are no objective criteria for what constitutes a paradigm shift, neither are there any for price shock events. Instead, I have found it useful to develop a hybrid discretionary-objective overlay for my mechanical trading systems that is based on highly aberrant increases in volatility. Whether the rest of the investment community decides that a particular increase in volatility was a price shock or not is irrelevant to me. Instead, the key is employing a robust criterion that forces me to reduce my exposure to market environments that could endanger my trading career.
Although there are certainly arbitrary numerical thresholdsâ€”such as a 50 percent increase in one-year historical volatility levelsâ€”that could trigger a reduction of volumetric exposure, because volatility exhibits both trending and cyclical tendencies, I hesitate to limit my definition of an aberrant increase in volatility to any static numerical threshold. Instead, I argue that a more robust solution to the issue of determining volatility thresholds includes the overlaying of a discretionary filter onto the objective, percentage-based threshold of a 50 percent increase in one-year historical volatility levels.
Discretion and Systems Trading
For example, if a 45 percent increase in one-year historical volatility is the direct result of an ultra-short-term, unsustainable headline-driven event (e.g., the capture of Saddam Hussein), then scaling back of volumetric exposure is probably unwarranted. By contrast, if a 20 percent increase in one-year historical volatility is the result of something that the trader determines to be due to an intermediate- or long-term shift in market dynamics (e.g., legislation leading to a shift in supply and demand), then a volumetric scaling back of exposure might prove a preferable course of action as opposed to waiting for the static 50 percent increase in volatility threshold to be breached.