Evaluating Mechanical & Discretionary Forex Trading
Evaluating Mechanical & Discretionary Forex Trading
Forex trading, much like many other types of financial market participation, is usually excuted using one of two approaches: mechanical or discretionary. In the mechanical trading approach, one relies on application of technical analysis to generate trade signals, and this is done in a very systematic way. Whereas in discretionary trading, the trader takes advantage of his/her experience in the markets to sieve and assess trading opportunities. There is an element of human judgment here.
Is one trading approach better than the other? How do you decide which one to choose? Let's have a look at the pros and cons of each trading approach and consider what selection criteria should be applied in each case.
** Mechanical Trading Approach **
1. A mechanical Forex trading approach has many plus points. Here, a trader follows very strict rules for trading, which keeps him/her in check to avoid emotional trading. There is no guess work, as it is very clear cut whether a trade should be entered or exited.
2. Mechanical trading gets trade signals from a system based on historical Forex trade data. Since Forex trading strategies crafted this way can be precisely back-tested with performance statistics to boot, this is seen as a benefit. Moreover, a mechanical trading approach lends itself well to automated Forex trading -- the trader can do Forex trading in the background via automatic system-generated trades sent direct to the broker.
3. The main downside of a mechanical trading approach is its inability to react to and follow new market conditions. As historical data is always biased to past market conditions, even if the system statistics show favorable performance there is no guarantee the system will continue to produce Forex profits today or in the future. Worse, the system can be tweaked to optimize performance statistics, which may create an illusion it works exceptionally well.
** Discretionary Trading Approach **
1. Discretionary trading utilizes mainly a trader's experience in the Forex markets, which can be good as the trader is able to single out higher probability trade opportunities and ignore the lousy ones. Since a human is involved in trade decisions, changing and new market conditions can be factored in quickly and adjustments made to the trading approach.
2. However, the human factor in the discretionary Forex trading approach can also be regarded as a drawback. It takes many years to gain the necessary Forex trading skills and experience, and very likely also a few accounts blown. Few traders can trade without emotion when money is at stake. The fact that the system is discretionary also means the Forex trader can be affected by hindsight to change trading rules arbitrarily. Lastly, trade automation is not feasible since a human is required to make a decision on every trade setup and when to exit trades.
Before you go ahead with either trading approaches, evaluate first you perform as a Forex trader. Do you doubt your trade setups? Are you the sort that keeps shifting stop losses as trades play out? Does being in a trade often evoke elements of fear, greed and anger? Perhaps a mechanical trading approach would fit you as it can alleviate most of these problems.
What if you have a special ability to hit home runs under certain market conditions? Or if you can "tell" that a trade setup might not work in a particular situation? And you are very disciplined and also emotionless when trading? Well, discretionary Forex trading may suit you better since you are in control and abnormal profits (with reference to mechanical trading) can sometimes be had.
Finally, there is also the idea of marrying both trading approaches to create a hybrid one. Consider taking the advantage of Forex trade automation from mechanical trading, so that you get trade evaluation and order entry covered. Slap on the option of human intervention to allow non-performing trades to be closed early, new trades to be selectively added on, and repositioning of target prices. This is like a best-of-both-worlds approach and is perhaps the ultimate choice for some Forex traders.
Whichever trading approach you elect to use, there are a few must-do rules to follow. Always know your risk before each trade, not trade a setup first and evaluate risk thereafter. Always use correct position sizing for proper risk and money management, so that you protect your trading capital. And do give time for the system to perform.
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