Pros and Cons of Mechanical Trading Systems

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Within the financial markets, there are two primary class of traders. The first group are considered system traders, and the second group are classified as discretionary traders. System traders rely on mechanical trading systems for buy and sell signals, and for executing orders in the market. Discretionary traders, on the other hand, rely on their own judgment as it relates to the decision-making process. Here, we will focus on system traders and present some of the pros and cons of  automated trading systems.

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What Is A Mechanical Trading System?

Mechanical trading systems, which are also commonly referred to as algorithmic trading systems, provides a trader the ability to program the rules of their trading strategy into a software platform. Once the code has been written, and properly tested, the mechanical trading system will then perform all the necessary trade related tasks in real-time. Essentially, it will auto trade your strategy for you.

These programmed rules would include entry execution, stoploss placement, trailing stop or take profit targets, and risk management parameters. Mechanical trade signals help alleviate many of the mundane tasks associated with initiating and managing a trading position. In addition, automated systems can enhance performance through a speedier execution process.

In today’s trading arena, algo trading systems comprise over 70 to 80% of all trading volume. This includes activity within the foreign exchange, futures, equities, and options market. As such, computerized trading systems have now become the driving force within the overall financial markets.

The popularity of auto trading has brought many different technologies and platforms to the forefront. Some of the more robust auto trading platforms available to retail traders include Tradestation, Ninjatrader, Multicharts, and Metatrader or to name a few. Many of these platforms are well suited for building futures and forex mechanical trading systems.

These platforms enable a trader to automate their trading strategies using their proprietary programming language. And often, they also include some limited ability to create a system without the need to rely on any complicated programming knowledge; meaning that can simply add in some conditional statements within the platform or engine which will then automatically codify your trading methodology.

If your trading method has a clear set of rules that can be applied in a mathematical manner, then it most likely has the characteristic of being programmed into an algo trading system. If on the other hand, there are many discretionary variables within your trading process which is not conducive to being quantified, then you will find it much more challenging to automate your trading technique.

Types of Mechanical Trading Systems

We can classify mechanical trading systems into three primary types, based on their time horizon. This includes the day trading timeframe, the swing trading timeframe, and the longer term position trading timeframe. Let’s take a look at each type in more detail.

Mechanical day trading system – An automated daytrading system seeks to hold positions anywhere from as short as a few minutes to as long as the end of the trading session, which could last several hours or more. Daytrading systems are very popular within the futures markets, especially within the equity indexes such as the S&P 500, NASDAQ 100, and the Dow 30. Due to the massive daily volume and intraday volatility, these markets provide an excellent venue for mechanical trading methods.

When selecting the viability of a market for day trading purposes, it’s important that you study the depth of market volume, the average daily range, and the transaction costs which come in the form of bid ask spreads, and commissions. The optimal day trading markets will offer a high level of market participation, and should have sufficient volatility to take advantage of intraday price swings. Additionally, the spreads should be very tight, preferably with a one tick spread in most cases. This will enable you to overcome the average friction associated with trading the smaller time frames.

Mechanical swing trading system – A swing trading system can mean different things to different traders. However, in the traditional sense of describing a swing trading method, it refers to trading within a timeframe that seeks to hold positions from as short as a few days to as long as a few weeks. Swing trading systems typically provide for a much better average win amount to average transaction cost ratio compared to most daytrading systems.

This is because when we are able to hold positions for a longer period of time, we give ourselves the ability to earn larger profits on a trade, while being able to keep the transaction costs relatively low in comparison.

Some traders find that when they simply switch from a daytrading approach to a swing trading approach, without initiating too many additional adjustments, that they can sometimes go from a losing or breakeven system to one that is relatively profitable. Automated swing trading systems are quite popular within the Forex market.

Some of the more popular pairs conducive to a swing trading model include EURUSD, GBPUSD, USDJPY, EURJPY, and GBPJPY. These instruments are highly liquid and volatile currency pairs which are well suited for various swing trading methodologies. And they can often be translated into an automated forex trading system.

Mechanical trend following system – Trend following systems tend to perform best at larger time frequencies. More specifically, trend following strategies that are built on weekly data tend to outperform most other time frames. By its very nature, an automated trend following system seeks to recognize and jump aboard an emerging trend and ride it out for as long as possible. As such, many trend following systems will typically hold onto positions for as short as a few weeks to as long as several months or longer.

Mechanical trading systems focused on this type of trend following approach, were popularized in the 1970s and 1980s by legendary traders such as Larry Williams, Bill Eckhardt, and Richard Dennis to name just a few. Trend following systems can perform well across many different sectors such as energies, metals, financials and agricultural products. So long as there will be catalysts that can create supply and demand imbalances, there will be opportunities for long-term trend followers to take advantage of price movements.

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mechanical-trading-systemBenefits Of An Automated Trading System

Some trading techniques are more aligned to systematic trading than others. And depending on your personality type and preferences you may be more comfortable with trading system design and execution than other individuals. In any case, it’s worth performing your own due diligence and testing to see if your particular strategy would benefit from an automated style of trading.

Mechanical trading systems offer several key advantages over discretionary based strategies. Let’s discuss some of these advantages.

Helps You To Control Your Emotions – One of the biggest obstacles that both novice and experienced traders need to overcome is their own emotional reactions in the market. Most times, traders have a difficult time controlling their emotions, and this can have an adverse effect on their overall performance.

A mechanical trade system helps you to overcome these inherent challenges, because by the very nature of a system based approach, most if not all trading decisions are delegated to the algorithmic system. Computers do not suffer from trade attachments or paralysis analysis as is common among discretionary based traders. As such, your preset trading rules will be executed efficiently in the market without second thought by the Trading Algo each and every time without exception.

Provides A Disciplined Approach – Once a trader has developed a positive expectancy trading model, they need to be able to execute in the market in a disciplined methodical manner. This goes hand-in-hand with trying to trade the markets with the least amount of emotions as humanly possible, in order to achieve the best results. A mechanical trading system provides a disciplined framework for executing your trading model.

Even if you are an exceptionally disciplined and engage in the markets with little emotion, there will be times when you will second-guess your set ups or potential trading opportunities. Or there may be times when you’re inherent biases lead you to either enter into or pass up on a position that is outside your prewritten trading plan.

These types of deviations, however minor, can lead to a snowball effect causing you to start trading in a manner that becomes inconsistent with your original outlined methodology. A mechanical based system always stays on track with its original preprogrammed parameters, making it far superior to humans in terms of maintaining a disciplined approach.

Backtesting Capabilities – Most trading system platforms offer a back testing engine wherein a trader can back test, optimize, and even forward test their strategies. They can often perform these tasks on huge sums of data in a relatively short span of time. This capability allows mechanical traders a distinct edge over discretionary traders. Whereas discretionary traders will typically have to back test their strategy using a more manual method, system traders can test their ideas very quickly and efficiently.

What’s more, computerized back testing is much more reliable than a back test that is performed manually. Mechanical traders can be confident in executing their strategies in the market because they have historical performance data and related metrics for their trading system. This added level of confidence can help mechanical traders to stick with their strategies, even during prolonged drawdowns, as there is a baseline from which to measure the trading performance.

Limited Human Intervention – In the markets, where the price action can sometimes be very fast, and volatile, a trader needs to be very careful in his execution decisions. This is often easier said than done when emotions run high, and the markets are trading in an irrational matter. Mistakes are likely to occur during such times. Even during normal trading conditions, there is a tendency for discretionary traders to make minor mistakes from time to time.

Mechanical trading systems are much better as an execution model since aside from any coding or programmatic errors, there will be very little if any unintended trading mistakes that occur. Your Algo or Expert Advisors will simply execute based on the underlying code provided and will not deviate from that written code in any event. This obviously leads to much less human intervention, which can translate to much less human error associated with the trading process.

Drawbacks Of Automated Trading Strategies

Let’s now look at some drawbacks of using mechanical trading systems:

Cannot Adjust To Unique Market Conditions – Mechanical trading systems will allow you to stay more disciplined and free of emotion in the markets due to the automated nature of the trading signals. This is an obvious advantage as described earlier, however, a trading system’s inability to think and adjust to unique market conditions can also be a drawback. For the most part, the trading activities within the market are fairly normal, but, there are certain occasions, particularly, during black swan type events, wherein human logic and critical thinking skills are more appropriate.

Since computerized trading programs may not react optimally during such conditions, it is the job of the trader to either have certain circuit breakers programmed into the system, or take decisive action to disengage the trading system temporarily as and when the need arises.

Programming Cost and Potential Coding Errors – There are several notable trading platforms on which you can build your mechanical trading strategy. We referenced a few of them earlier. To get the most out of these platforms, you will incur a subscription cost or a one-time purchase cost. Although, the pricing for these retail based algorithmic trading platforms have become more affordable, they can still run in the thousands of dollars. This may be cost prohibitive for some traders who are interested in a system based approach.

In addition to the additional cost of the algorithmic platform itself, there is also a cost associated with hiring a professional programmer to code your mechanical system. This can obviously be bypassed if you are an experienced programmer yourself.

Another related drawback that needs to be considered is the presence of coding errors within your system. You need to thoroughly test and debug your system in order to ensure that all of your parameters and execution processes are being performed as intended. This can sometimes be a time-consuming process but something that nevertheless needs to be done before committing your hard earned funds to trading that particular system.

Can Run The Risk Of Being Over-Optimized – Most mechanical trading platforms allow you to not only build your trading system, but also gives you the ability to back test and optimize your strategy. Traders need to be very careful when they are viewing back tested results. Hypothetical results can sometimes appear great on paper; however, that same system will often perform dismally within real market conditions going forward.

There may be many different reasons for this, which is beyond the scope of this article, but there appears to be one recurring theme that is common among these types of systems. And more specifically, that is when you either cherry pick or limit your back testing to a data series that only exhibits a specific market condition, it will often lead to unrealistic and subpar results in the future.

Additionally, many systems traders fall into the trap of over optimizing their system in an effort to find the very best parameters or to create the very best trading system. This often leads to inadvertently creating a curve fit system, which only serves to demonstrate the effectiveness of the strategy on the historical data, and one which may be close to useless in the real market environment.

One way to overcome this, is to forward test the mechanical trading system to ensure that the results are within a reasonable variance to the historical test. This will get you closer to realizing whether or not you have a proven trading system.

Risk Of Mechanical Failures – Last but not least, a mechanical trading system needs to be closely monitored to ensure that everything is flowing smoothly. That is to say that, since there are so many different moving parts that need to work together seamlessly, there is the added risk of one of those components malfunctioning which could throw the entire system in a tailspin.

In an effort to reduce mechanical failures, system traders will usually run their programs on dedicated virtual private servers, also called VPS. But even that is not without risk. There can be communication issues, connectivity issues, compatibility issues, software issues, system design issues, and a host of other problems that can affect the trading system. Systems traders need to be ever cognizant of these hardware and software related risks, and incorporate proper measures to minimize any adverse effects.

Download the short printable PDF version summarizing the key points of this lesson…. Click Here To Download

Final thoughts

As we’ve seen, mechanical trading systems have much to be desired. But on the flipside, there are certain disadvantages as well that aspiring system traders should be aware of. Each trader should balance the pros and cons of an automated trading approach, and decide whether or not it suits their style of trading.

Aside from the personal preference of robot trading versus discretionary trading, there is also a consideration that needs to be made from the practical sense. In other words, there are certain types of strategies that are more amenable to a systems trading approach. For example, trading methods that can be easily quantified mathematically or through a set of indicators will be more conducive to programming then a trading methodology that relies more on intuition and judgment.

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