Wednesday, September 08, 2010

Is Mechanical Trading Right for You?

Mechanical Trading Systems
What Does Mechanical Investing Mean? By Investopedia

Buying and selling stocks according to a screen based on predetermined criteria, usually with the help of technical indicators such as relative strength or momentum. This method allows traders to enter transactions without emotion and backtest their strategies by using historical data from any time period.

For example, one of the most common mechanical investing systems is called the Dogs of the Dow. This strategy involves buying the 10 stocks on the Dow Jones Industrial Average with the highest dividend yield at the beginning of each year. The portfolio is then adjusted each year to only include the 10 highest yielding stocks. Proponents of mechanical investing say that using this method of investing removes all emotion by allowing a computer to do the work of deciding whether investing in a certain asset is warranted.

Is Mechanical Trading Right for You?

By Ken Long Long of Van Tharp Institute

When considering any trading strategy, your main criterion should be bottom line performance, that is, your bottom line performance. The primary question to answer is, “Could I execute the trading strategy according to the rule sets as defined?”

In this sense, whether a system is purely mechanical or discretionary or some combination of both is irrelevant. The rule set either makes money according to the plan or it doesn’t. If it does, then you can either follow those rules or not and make money or not.

Before you commit a lot of time and money to developing or investing in a particular trading system, it would be nice to know if your personality type fits that trading system. A lot of people believe that while they are working on developing their own trading system that fits them really well, they can trade a mechanical system since they just have to follow its rules to make money. Then, they discover that the mechanical system needs some of tinkering: bending the rules or otherwise adding a dose of discretion. Tinkering means breaking the rules (which may not have fit them) and they find they don't make money, even though they know the mechanical system makes money. It comes down to following the system's rules.

Here’s an example from my own trading experience from which I have had to learn to leave a system alone and follow its rules—even though that’s hard.

I have a mechanical system that is in the market only 10 to 15% of the time in a given year. It waits for specific high probability conditions to arise in the market, then it takes a position that is clearly against the mass psychology. It aims to capitalize on the market’s tendency to revert to the mean after extreme moves. The rule set guarantees that you enter the market in a direction completely opposite of what your natural human psychological tendencies advise.

I have back-tested this system extensively in multiple market types over the past 15 years with great results. I have traded it profitably with real money for more than four years. I have abundant evidence to be rationally satisfied that this system has a high probability of success and reliable results. Every time it fires a signal, though, I am still uncomfortable entering the position because of my psychology. I have had to learn how to accept the uncomfortable feeling as a positive sign of a good trade. Now I manage my psychology so that I can enter the position at appropriate risk levels when the system generates the signals.

In a larger sense, I think the following elements are necessary for pure mechanical traders:

* They have confidence in their analytical judgments.

* They have confirmed the reliability of the system.

* They have identified the risk level that allows them to apply their trading system without the danger of blowing up.

* They are committed to their periodic performance review and can approach the entire situation with analytical mind and rigor.

These are rare qualities for most people but for someone who wants to develop and exploit a good mechanical system, they are ideal.

Click here to learn more about Ken Long and the Van Tharp Institute

Click here for Dr Van Tharp Trading Workshop Schedule