Ask the Expert - CFDs What is a mechanical trading system, and does taking the emotion out of trading lead to fatter profits? Matthew Press, Head of Sales , FP Markets
What is a mechanical trading system, and does taking the emotion out of trading lead to fatter profits?
Today's expert: Matthew Press, FP Markets
The deciding factor of a traders success will in the vast majority of times hinge on how their emotions cope under the pressure of trading rather than their trading methodology.
Mechanical trading systems, are a method of trading that takes the emotion out of decisions as trades are made based on predetermined signals but does removing emotions from the equation lead to increased trading profits?
Theoretically, yes. Mechanical trading systems allow traders to input the market data, and the system then generates a response that indicates the appropriate action. The instruction is to buy, sell, or take no action, depending on the formulas that the system uses. Expressed another way, mechanical trading systems are a method of generating trading signals and quantifying risk, independent of a traders discretion.
While there are many advantages in using a mechanical trading system, the majority agree that the greatest benefit lies in the removal of a traders emotions from the decision making process.
True mechanical trading involves the development of trading rules that define every situation, from entry, to exit, to position sizing. A trader then executes every trade the system provides based on the predefined plan. This can be difficult for many traders, especially if they let their emotions become a factor in their decisions rather than just obeying the trading system.
The first step in formulating a winning mechanical trading system is accepting that the approach is a numbers game with predetermined rules and a structured style to investing. The basic concept relies on understanding the percentages and trading to a plan without giving in to emotions. The approach is seen by many to provide a better long term outcome for traders and investors.
Most mechanical trading systems will always have the trader invested in the market, either long or short. Success using a mechanical trading system, like all other trading, depends on adherence to thorough risk management strategies. As such, the exit level of a trade is determined prior to a trade being entered.
The mechanical trader spends time developing a system and does not need to think while trading, merely executes a plan. This differs from a discretionary trading style which relies on a trader’s judgment.
Broadly, mechanical systems are developed from two approaches recognized as ‘Trend Following’ or ‘Mean Reverting’.
Trend following aims to profit from longer-term easily recognized price action in financial markets. Traders who use this approach can use current price calculation, moving averages and channel breakouts to determine the general direction of the market and to generate trade signals.
In contrast, mean reversion is a method that suggests that prices and returns eventually move back towards a mean or average price. This mean or average can be the historical average of the price or return or another relevant average such as a related company, sector or index. Mean reversion systems will give signals that involve the purchase or sale of other stocks or other securities whose recent performance has greatly differed from a historical average.
Traders will achieve highest success through an approach which incorporates method and discretion. Coming to the market with a proven methodology rather than relying on emotions will improve your potential trading success. However, the markets are always changing, and your strategy needs to be continually updated to reflect the changing markets.
Many traders will use a mechanical system to generate buy and sell signals but then use discretion, reading the market, to attempt to gain better entry levels. It can be recognised that successful traders will use a proven trading methodology.
Successful trading requires discipline, and mechanical trading can certainly make a positive contribution to the process. Methodology is the key, a plan is essential and it’s important that you stick to your plan and adjust the plan to reflect changes in conditions.
Mechanical trading fits to a plan, it provides consistency and only signals new trades or exits that meet the specifics of your trading methodology are taken. It removes opinion and emotions resulting in improved trading discipline. However, while success is not guaranteed with a Mechanical Trading system, traders who stick to their plan benefit from improved control and can achieve greater success.
Disclaimers: The views expressed in this article are those of Matthew Press, a representative of FP Markets and is not intended as general advice. This does not constitute a recommendation nor does it take into account your investment objectives, financial situation nor particular needs.
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