Section III: Types of Trading Systems
There are basically two types of Forex trading systems, mechanical and discretionary systems. The trading signals that come out of mechanical systems are mainly based on technical analysis applied in a systematic way (technical indicators, chart patterns, etc).
On the other hand, discretionary systems use experience, intuition or judgment on entries and exits.
Which type produces better results? Or more importantly, which one better fits your trading style?
In this section, we will try to answer the question above. We will first analyze the pros and cons of each system approach.
- This kind of system can be automated and backtested efficiently.
- They have very rigid rules. Either, there is a trade or there isn’t.
- Mechanical traders are less susceptible to emotions than discretionary traders.
- Most traders backtest Forex trading systems incorrectly. In order to produce accurate results you need tick data.
- The Forex market is always changing. The Forex market (and all markets) has a random component. The market conditions may look similar, but they are never the same.
- A system that worked successfully in the past doesn’t necessary mean it will work in the future.
- Discretionary systems are easily adaptable to new market conditions.
- Trading decisions are based on experience. Traders learn to see which trading signals have a higher probability of success.
- They cannot be backtested or automated, since there is always a decision to be made based on judgment.
- It takes time to develop the experience required to trade successfully and track trades in a discretionary way. In the early stages this can be dangerous.
Now, which approach is better for Forex traders?
It is advisable to always start trading a mechanical system, as you gain experience, you will realize which signals produce better results but this requires time and experience, so start first with a mechanical system. Another point you should take in consideration is if you are a trader that finds it hard to follow your trading signals, then you are better off using a mechanical system, where your judgment won’t play an important role in your system. You only take the trades that your system signals.
If the psychological barriers that affect every trader (fear, greed, anger, etc.) puts you in unwanted scenarios, you are also better off trading mechanical systems, because you only need to follow what your system is telling you, go short, go long, close a trade. No other decision has to be made.
On the other hand, if you are a disciplined and experienced trader, then you are better off using a discretionary system, because discretionary systems adapt to the market conditions and you are able to change your trading conditions as the market changes. For instance, you have a target of 60 pips on a long trade, the market goes up quickly reaching 50 pips in your favor in a few minutes, allowing you to change the target level to 100 pips. These kinds of decisions are nice to adapt once you have enough experience, however it could be dangerous at early stages.
Does it mean that trading a discretionary system has no rules? This is absolutely incorrect. Trading discretionary systems means that once a trader finds his/her setup, the trader then decides what to do. But every trader still needs certain rules that need to be followed, such as the size of the position, conditions that have to be met before thinking to get into the market, and so on.
Whether you choose to be a discretionary or a mechanical trader there are some important points you should take in consideration:
- You need to make sure the Forex trading system you are using totally fits your personality. Otherwise you will find yourself outguessing your system (develop it yourself).
- You also need to clearly define your rules and most importantly have the discipline to follow them.
- Take your time to build the perfect system for you. It is not easy and requires time and hard work, but in the end, if done correctly, it will give you consistent profitable results.