There are two basic types of traders, discretionary and systematic. Discretionary traders attempt to figure out the lay of the land, the supply and demand as well as the macroeconomic and political outlooks on the markets they trade. They assimilate all of this information into an overall outlook on a particular market and synthesize a trading plan from those inputs. Most billionaire traders are discretionary. They are able to discern patterns that are not programmable and they are able to vary their bet size to match the current market conditions and their overall risk profile. Richard Russell, who I mentioned in last week’s article, is a discretionary trader. Some more famous names include George Soros, Paul Tudor Jones and Julian Robertson.
Successful discretionary trading has become increasingly difficult due to the global political factors that make us all wonder what tomorrow’s world will look like. Will the Euro burst? Will Syria use chemical weapons and catalyze a new Cold War between the U.S. and Russia? These low probability yet, high impact possibilities have made it harder and harder for discretionary traders to try and picture the world two, five or even ten years down the line. This is also the type of timeframe they need to position the billions of dollars that they manage. The net result is that many of the world’s largest hedge funds and money managers have been moving to cash. It is becoming increasingly clear that they would rather not invest than try to guess correctly in a world that changes the rules both domestically, and globally by the day.
The mass exodus can be seen in the markets through declining trading volume. Trading volume in all major indices has steadily declined since the market bottom in February of 2009. The brief uptick last September was barely more than half the volume we generated in ’09. Both the industry and the government have shaken investor confidence. Three quickly attributable causes are the demise of trading firms like Bear Sterns and MF Global, governmentally imposed restrictive short selling rules and the attack on high frequency trading. These events shake the faith in the system and force participants to the sidelines. Clients need to know their accounts are secure, that their positions pass muster and that bureaucrats won’t destroy the laws of liquidity.
Systematic traders base their decisions on black and white rules or algorithms that will spit out the same response relative to the input received time and time again. Many trading systems were built on rules that held fast throughout the 90’s and 2000’s until the markets collapsed and the government got involved with quantitative easing programs and Treasury repurchases. The government’s artificial manipulation of the markets relegated the historical rules of market relationships worthless. Therefore, many of the premises that these mechanical systems had been based on became not only useless but wrong. They became the equivalent of, “GIGO” garbage in, garbage out. The exit of mechanical trading systems from the market has further diminished overall market liquidity.
Manipulated prices by governments and ratings agencies have rendered the inputs of the decision models used by discretionary traders and the mechanical models of trend following systems virtually useless. Ironically, this brings my personal trading philosophy full circle. My discretionary trading came to an end shortly after I left the trading floor of the Chicago Mercantile Exchange. Discretionary pit trading allowed me to vary the size of my trades by being able to read the order flow and allowed me to capitalize on flush trading opportunities. However, a couple of years after returning to Sandusky, Ohio to raise kids, I began to focus on mechanical trading systems. I understood that the game had changed and I needed new tools to successfully trade from a screen instead of the trading pit. The sole input to many of my early trading systems was simply the price of the market I was trading. The philosophy was, “There is no way I can assimilate all the variables in a market and cross reference the associated data streams. Therefore, I will assume that the fair value for the market I am trading is the last traded price. After all, it reflects all of the variables I’m trying to quantify.”
The major advantage to trading systems is that one brain doesn’t have process the day’s events of the world and attempt to predict how they will impact the market being traded. There are times when a trader will nail a government report number right on the head only to have the market react in a completely different manner than had been expected. It’s a hollow feeling to be right and lose money. The primary objective of participating in the markets is to turn a profit. The fewer things make sense, the more important it is to know our own limitations. Mechanical trading may not hold the same potential of the great discretionary traders but it does allow me to grind out an expected profit.
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