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In either instance, the introduction of discretion into the mechanical trading framework did not represent an abandonment of a disciplined response to the signals generated by the trading systems. Furthermore, unless the increase in volatility is so severe that the prudent course of action (based on equity under management) precludes continued participation in that particular market, the introduction of a discretionary filter merely results in a potential reduction in volumetric exposure to the trading signals generated by the system(s).
Of course, the introduction of the 50 percent increase in historical volatility threshold is merely one of innumerable objective criteria that could be used as a trigger for reducing volumetric exposures. In fact, Chapters 7 and 8 alluded to other potentially useful thresholds, including environments in which historical profit levels are exceeded by over 150 percent, along with the breakdown of historically stable correlations.
If the introduction of trader discretion ultimately could result in the abandonment of a successful mechanical system and if blind adherence to a mechanical approach could yield suboptimal results if a price shock or paradigm shift occurs, perhaps the answer is to create a comprehensive set of rules that would dictate when trader discretion could be introduced. Although such rules are virtually infinite, some ideal candidates include increases in volatility beyond a specified percentage threshold, exceeding the maximum number of consecutive losses in the system’s backtested history, and achievement of unprecedented per-trade profit levels.
All examples of objective criteria for the introduction of discretionary elements provide a more robust price risk management methodology. As long as we allow stringent adherence to the principles of price risk management to remain our blotter test, the introduction of a discretionary element into our arsenal of trading techniques cannot degenerate into many of
MECHANICAL TRADING SYSTEMS
the common flaws of novice discretionary trading (e.g., inability to cut losses, increasing position size after losses, etc.).
PROS AND CONS OF “TRUE” DISCRETION
So far I have addressed only the issue of objectively quantifiable criteria to introduce discretionary overrides for mechanical trading systems as defined by the trading system’s backtested results and/or the historical volatility of the assets traded. Once I include quantifiable fundamentals, such as purchasing power parity,1 sentiment indicators (e.g., put-call ratios, commitment of traders reports, etc.),2 and interest rate differentials, or “fuzzy” fundamentals, such as headline news events, the value of including such discretionary overrides becomes somewhat murkier.
This does not mean that the utilization of fuzzier discretionary overrides on a mechanical trading system is without merit. Instead, I am simply pointing out that inclusion of such overrides could call into question the continued validity our trading system’s in- and out-of-sample results. Furthermore, once such results are no longer indisputable, risk tolerance measures such as maximum consecutive losses and profit to maximum drawdown ratios also become problematic.
There are and, in all likelihood, there will continue to be obvious moments in which traditional discretionary overrides are prudent performance enhancement tools. While I recognize and freely acknowledge this fact, I merely add a note of caution that once discipline has been overridden without violation of some objectively quantifiable threshold, a dangerous psychological precedent is set in motion. As a result, until traders successfully demonstrate their ability to sustain consistent, disciplined adherence to a mechanical trading system over a prolonged period of time, I suggest that they reject fuzzier discretionary overrides in favor of simple, objectively quantifiable rules of entry and exit.
Psychology of Mechanical Trading
Trading Systems and Transformational Psychology
I count him braver who overcomes his desires than him who conquers his enemies; for the hardest victory is over self.
DISCIPLINE AND FLEXIBILITY
Although discipline and flexibility might sound like mutually exclusive terms, as I have shown in Chapter 10, this is not the case. Traders must be disciplined enough to consistently execute trades irrespective of personal winning or losing streaks, bullish or bearish market consensus. Such a disciplined approach usually entails mastery of open-mindedness so that they can continuously view things differently from the crowd. Moreover, mechanical traders must be flexible enough to abandon their disciplined adherence to a trading system once that system is no longer robust enough to generate profits (due to a paradigm shift in market behavior).
Zen Buddhist philosophers often attempt to explain the nonlinear nature of reality with paradoxical phrases: true, false, both and neither, all at the same time. Although at first glance the phrases seem nonsensical, it is the essence of the multidimensional nature of all things, including market behavior. Moreover, the phrase epitomizes the flexible mind-set of successful traders. For example, I can state: “It is true that traders succeed by following the trend.” Yes, this is true for trend traders, but it is false for nondirection-ally biased mean reversion traders. Next, I can say that the statement is both true and false because some system traders employ both trend-following and nondirectionally biased mean reversion models simultaneously. Then it