April 21, 2020

Mechanical Trading. Trading the randomness

By equrve

Mechanical Trading can be defined as “a form of trading when a trade is taken based solely on pre-defined signals and any kind of intuitions or discretion is not used “. When trading stocks and futures markets, mechanical trading should be the first step and also the last for most traders. Mechanical trading is easy to learn, and discipline is the key.

Mechanical Trading is following the rules
Mechanical Trading requires trader to stick to a predetermined path

Most traders do have systems which gives them setups/signals for entries and exits. But then the decision to enter/exit a trade is based on their understanding of what is currently happening in the market. This is not a mechanical form of trading, even though the trader has signals in place to help with the decision.

Mechanical Traders are traders who totally rely on their signals to tell them what to do. And do not question the rules of the system no matter what is they think of the market at the moment.

The secret ingredient of mechanical trading

The biggest advantage of mechanical trading is that this is a form of trading where you have to control only what you can control: “Yourself“. Mostly in discretionary trading, traders are trying to judge the pulse of market. In mechanical trading we don’t have to do that. You do not have to be an expert at finances or know about market behaviours. This also reduces or removes the disappointment factor. Traders who trade in mechanical way always know and embrace the probability of every trade.

As a mechanical trader, news is not important, what is going to happen is not important. The only thing that is important is a set of rules and the traders ability to execute them without a moment of doubt. This can take a bit of practice and make your days more boring, than you would like. But this is something that gives its sweet fruits in sweet time. The biggest obstacle that you can face as a mechanical trader, is with your own discipline. Once you master that, mechanical trading is easiest form of trading.

An Example of a mechanical trading system

As an simple example lets say a trader has a system where entry rules are :

For Long:

  • Timeframe is daily chart
  • Entry when 13 EMA line crosses above 50 EMA
  • Exit when 13 EMA goes below 50 EMA
  • Exit when price falls 20 percent below the high made after entry.

In a fully mechanical system the trader will stick to these rules irrespective of what is happening in the market at the moment. For example, in the current scenario with the covid-19 outbreak, the general mood in the market is bearish. So traders might want to avoid long entries. But not a mechanical trader. In the above example, a mechanical trader will take the long entry when 13 EMA crosses over the 50 EMA. The fundamentals, the news outside and the general mood of the market is irrelevant.

Accept your limits

When trading in a mechanical way, the most important thing for the trader is to understand and accept that he/she has no knowledge of why the market behaves in a certain way, and that it is completely random. This is a difficult thing bring our mind of accept as we are programmed to always find reasons for why something happened. Even while trading if we see the stock market or a particular share move, we want to understand why it happened.

But that said, mechanical trading is also much easier than actually understanding the market. The biggest advantage of being a mechanical trader is that you have to work with yourself and just yourself. You need to understand and implement yourself into a process that you can follow without having to second guess the market.

The rules in mechanical trading are not rules for the market. The market is not supposed to go up just because your long entry is hit. Neither is the market supposed to go down because your Stop Loss is hit after a long entry. The market will do what it wants to do. The mechanical rules are for the trader.

Reaction based Trading:

Mechanical Trading is reaction based trading. The rules tell us how to react when a certain thing happens. And the market really does not care about how we reacted. Again in the above example, whenever 13 EMA crosses above the 50 EMA, a long entry is made at market price. Then a Stop Loss is placed and trailed which is 20 percent from the highest point after entry. Also we have another exit when 13 EMA goes below 50 EMA. So the mechanical trader will exit as soon as one of the above conditions are met.

The other more important factors:

This is a very simple example. And there are other factors that are very important part of mechanical systems, like position sizing, risk management. In a mechanical system the risk and position sizing are always calculated mathematically instead of a gut feel on how bullish and bearish the market is.

A risk in simplest terms is how much money we are ready to lose. So in above example to complete the system lets define an acceptable risk of 2 percent and assume we have a total capital of 100,000. This means that in every trade the acceptable risk (amount we are willing to lose) is 2,000.

Suppose a stock does the crossover EMA and closes at 100 (for simplicity). Our Stop loss is going to be 20 percent below so at 80. This gives us a risk of 20 per share. Now since we are ready to lose 2 percent of our capital which is 2,000. So find out the position size(quantity that we will trade), we simply divide 2000/20 which is 100. When we buy 100 our actual investment is going to be 10,000 only even though we have a capital of 100,000.

To summaries. Mechanical Trading Systems should have rules that are well defined and do all the work of finding:

  • Entries
  • Exits
  • Risk
  • Position Size
  • No use of gut feels and intuitions