Strategies vs. Systems (Part V)

I’m in the process of breaking down quite the mouthful from Part III of this series (http://www.optionfanatic.com/2012/05/23/strategies-vs-systems-part-iii/):

“If you are a discretionary trader then you have trading strategies with guidelines… [this] relies somewhat on common sense and gut instinct.”

Today I will finish by discussing the latter.

“Gut instinct” is a type of knowledge that may be difficult or impossible to describe as binary statements or programmable criteria.  The guidelines are meant to be generalities subject to change depending on what discretionary traders believe to have typically occurred in the past when these observations were made.

Since this does not reduce to programmable criteria, the biggest problem with gut instinct is the inability to backtest trading strategies.  Maybe your gut would have proven correct one or two times.  Would it have proven correct most times out of a large number of instances, though?  These may be hard to determine without using software to scan the universe of markets over long periods of time.

Because it cannot be objectified, gut instinct lends itself to biased thinking.  Confirmation bias is the tendency for people to favor information that confirms their beliefs.  This leads to overconfidence because it’s not necessarily true that gut instinct has proven itself correct time and time again–it simply has yet to fail.

Gut instinct also falls prey to the availability heuristic, which is when you mistakenly believe something at the forefront of your mind is something that has occurred often.  For example, if you recently saw a moving average crossover generate a profitable trade then you may be more likely to trade similar crossovers in the future.  One instance does not make for a robust phenomenon; it may simply be good luck.

In the next post, I will break down characteristics and qualities of algorithmic trading.

Strategies vs. Systems (Part IV)

In my last post (http://www.optionfanatic.com/2012/05/23/strategies-vs-systems-part-iii/), I said quite a mouthful.

Let’s break it down.

“If you are a discretionary trader then you have trading strategies with guidelines… [this] relies somewhat on common sense and gut instinct.”

Discretionary traders claim to know their market through lengthy study and/or live trading experience.  They claim to have a feel for how the market moves–slow or fast, volatile or nonvolatile, cyclical ranges, etc.  They claim to have a feel for common price patterns, tendencies, and fake outs.  Based on this assumed understanding, discretionary traders develop trading strategies with guidelines.

“Common sense” includes tendencies that sound logical.  For example, it sounds logical to reduce exposure to the market ahead of big news announcements or known events when you don’t know how the market might react.  Discretionary traders often include logically sounding guidelines in their trading approach regardless of whether these boost or detract from profitability.

The unfortunate fact is that common sense trading guidelines often end up producing unprofitable trades.  This is evident in the thousands of trading systems based on common sense criteria that have generated unimpressive results.  The only way to know if inclusion of common sense guidelines is beneficial would be to define some trading rules and backtest them.  This is more work than most [discretionary traders] are willing or able to do.

In my next post, I will wax eloquent for a while about “gut instinct.”