Saturday, May 31, 2014

Trend following - systematic or discretionary?

I have recently been re-reading Super Trader by Dr Van K Tharp, who has influenced my own approach (as well as countless others) to the markets over the years. While reading this I came across something which was the polar opposite of my own beliefs regarding two traders whose methods I used as a basis for my own system parameters.

According to Dr Tharp, Ed Seykota is classed as a systematic trader. As a comparison, Richard Dennis and the Turtle traders (who I considered to be extremely systematic in their approach) were deemed to be 'rules based discretionary traders'. 

While the difference may be considered to be esoteric, in essence what he is saying is that with a systematic approach, the whole process is programmable and automated. In theory, psychology is eliminated from the equation. Everything is quantifiable. You can stick it all in a PC, and let the system run.

Rules based discretionary traders, on the other hand, do have written rules they follow, but there is an element of discretion in what they do.

I have never had the good fortune to meet or correspond with any of these traders, therefore I am relying upon what has been written about them or by them over the years.

Van Tharp's assertion's got me thinking, and I referred back to Seykota's Market Wizards interview. There is a lot in there which suggests that he is quite discretionary in what he does, some of which I've shown below. Reading these extracts, would you say the he is a systematic trader or a rules based discretionary trader?

"I handle losing streaks by trimming down my activity. I just wait it out. Trying to trade during a losing streak is emotionally devastating".

On using contrary opinion (at a goldbug conference, virtually all the speakers were bearish, and Seykota said to himself that gold is probably near a bottom). Asked if he would buy, he responded: "Oh no, the trend was still down. But it might get me to lighten up my short position."

"I still go through periods of thinking I can outperform my own system, but such excursions are often self-correcting through the process of losing money."

"Systems trading is ultimately discretionary. The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase and decrease the trading base as a function of equity change. These decisions are quite important - often more important than trade timing."

"As I keep trading and learning, my system (that is the mechanical computer version of what I do) keeps evolving. I would add that I consider myself and how I do things as a kind of system which, by definition, I always follow. Sometimes I trade entirely off the mechanical part, sometimes I override the signals based on strong feelings, and sometimes I just quit altogether."

On his poor year in 1980: "I tried to pick tops and bottoms in what I considered grossly overbought and oversold markets. The markets just kept on going and I lost a lot."

With regard to my own approach, I guess on reflection I fall into the rules based discretionary traders camp. This is because I am selective in what I trade - some of which is based on the rules or criteria via my scan codes, and partly because of the 'visual characteristics' I look for. There is also the question of risk management. With a potential universe of 10,000+ worldwide stocks I could trade, there has to be some manual filtering out of trades in some way or other.

What I WOULD say is that, once I am in a position, I am extremely systematic in what I do regarding ongoing trade management (trailing stop placement), and the subsequent exiting of the trade. Being disciplined in your approach and following your rules as closely as possible will keep your mistakes to a minimum.

As a historic example of the differences between the two approaches, we return to the 1987 stock market crash. In a systematic approach (such as used I believe by the Turtles) they were fully loaded in their positions and were in major profits on the day of the crash. However, the day AFTER the crash all the profits accumulated over the previous few months had gone. A sharp move in some of the markets they traded meant there was massive slippage on their exits. In his book Way of the Turtle, Curtis Faith has referred to suffering a 65% drawdown overnight - he was down $11 million overnight on the $20 million account he was trading for Richard Dennis.

Yet there were other traders utilising a trend following approach who used their discretion, rather than blindly follow what the system said. The markets and the financial world were in shock with what happened. Rules were being re-written. Some took the decision to cash in their chips on the day of the crash and get out, even though they were trading in the direction of the trend. As a result, they avoided that huge overnight reversal, and kept the bulk of their profits.

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