The Better Part of Valor — and Your Trading System — is Discretion

There are many misconceptions about creating a mechanized trading system. Some feel that mechanized systems are better than discretionary systems as if they give a trader an edge. I think this may be true for those traders just starting out. However, I personally know many discretionary traders that have done just fine without systems. The key is to do what’s best for you. Allocators will give money to traders who can perform. Lastly, discretionary trading is a form of a system unto itself. More on this in another post.

I tend to see those traders who wish to become CTAs going the mechanized system route and those that are endeavoring to become prop traders go the discretionary route. What separates them is either years of experience and normally a focus on one instrument or sector.

Overall, I believe that it’s a great idea for a new trader to get to know and build systems from scratch with a simulator such as Trading Blox, for example, to get a very intimate understanding of all the moving parts that involve a trade: volatility, volume, price action, trends, and large counter-trend moves to name a few.

What’s lost on most most new traders is how their emotional intelligence is a major factor on their mechanized trading rules. Hint: they’re there whether you know it or not.

For example, if you are a risk taker in life, you’ll find that your personality type is manifest in your ultimate trading system. If you tend to be methodical and “slow and steady,” you’ll find that your approach to your mechanized trading rules is the same. If you don’t trust yourself, you won’t trust your system no matter how long you spend putting it together. If you have self-doubt, your rules will likely be the perfect system for generating tons of indecision and self-doubt.

Ultimately, all the decisions you make in creating your trading system are discretionary. That includes how much to risk per trade, positions sizes, entries, exits, and what instruments to trade. To say it in writing, there are no rules in creating your trading rules. That’s where your intelligence, emotional constitution, sense of self-awareness, and emotional intelligence all come together. I think the best traders are strong in all of these areas. Wisdom in these areas does not come easy. After I’d completed a great deal of what some of you are about to endeavor, I STILL needed to get my head handed to me. I documented a great deal of what I needed to live through in my book.

You are using your judgement and are weighing the tradeoffs between parameters and hypothetical outcomes to see which “feel” best. Feel here is emotional not intellectual, ie, “I’m scared and fearful about my long gold position,” not “I’m bullish or bearish on gold.” How you feel will affect your behavior and your behavior determines and predicts where you end up in life.

You can set up a system to be geared for triple-digit returns or for fractions of percentage points per month. You get to make those decisions, and as such, your system like all others has a discretionary element. But know this: if you swing for the fences, you’ll have to live with large drawdowns (realized and unrealized losses). You determine the calibration of these tradeoffs — and that is discretionary. Keep in mind, small hypothetical gains go with smaller drawdowns of shorter duration, and large hypothetical gains go with larger drawdowns of longer duration.

Discretion Two Times: Creating the rules and then following the rules.

Creating the rules is discretionary. Following them can be mechanical. The key is how much of your rules capture how you feel in the NOW-NOW and later-NOW. And that’s hard because there are those of us who believe that the future (the later-NOW) doesn’t exist: all we have is the ever-evolving moment of NOW, the NOW-NOW. Knowing how your feel later-NOW is hard to predict. But you’re likely to have an emotional system that you’ve been running for years, and as such, you might be able to get a sense how you’ll behave in the later-NOW because you’ve been doing it for years. That’s where self-knowledge is absolutely key.

[Your emotional system has the part that you’re aware of and the other part that you either don’t want to look at, or is subconscious and you’re not aware of it. That’s where a men’s group or a Trading Tribe can do wonders for you. For me, I have always put my money where my Tribe is: I was a member of the IVTT for 2 years (while living in LA) and I also concurrently ran the LA Tribe. That means I had a Tribe meeting every week for 2 years.]

What makes your system completely mechanized comes down to your ability to follow the rules alongside your emotional system. At best, the two have converged or at least are running parallel as your grow both intellectually about using Trading Blox, for example, as well as learning a great deal about yourself.

Discretion can appear after you’ve built out your trading rules, even with the help of a simulator. You can get a signal to enter or offset a trade and not follow it. Over-riding your rules here is discretionary. You may not have a signal from your system, but have a bona-fide hunch about an instrument and you affect a trade outside your systematic rules and put it on. That too is discretionary.

Neither use of discretion at this point are bad, evil, or wrong. You get to determine the rules and how you want to stick to them. They are your rules and they are personal. No one can tell you what’s best for you other than you. Even if you look to Bill Dunn – a fully systematic trader – you can have an element of discretion in your trading.


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