Mechanical Trading Systems

A systems or mechanical spread trader is one who utilised a trading system or a set of rules on when to enter and exit a trade. This trader would have everything worked out in a system before putting in a spread trade. A system will include rules about: how much to allocate per trade, when to enter trade, when to exit a trade and how much to risk on each trade.

Increasingly, and particularly in the Forex field, we are seeing a lot more ‘black box’ systems that purportedly generate reliable buy and sell signals, or even trade for you. They can be programmed to follow sound principles, and may even have good results for a time, but they are no substitute for sound judgment and thinking. Technical analysis is the art of interpreting a number of different and reliable scientifically derived indicators, and mechanical systems are scientifically derived indicators. There has never been a perfect mechanical trading system and there never will be.

Mechanical systems can be useful in two ways. The first way of using them is to take the results from the mechanical trading system and use them as just one more indicator in the decision-making process. In this way, they are a filter for the other factors.

Secondly, you can tell a mechanical trading system to take action on every signal, and with a well-thought-out system this may generate profits over time. There will be winning and losing trades, but if you choose to censor these you introduce the risk of emotional decisions, and lose the benefits of the mechanical approach. The strength of a mechanical system is to remove emotion from trading.

As mechanical systems are based on historical data, they will not necessarily perform acceptably in the future, as market conditions can change. It’s generally not worth fine-tuning the system for a perfect fit to past events, and you shouldn’t invent special rules to accommodate history. A system based around good general principles should give a reasonable performance. You can use your software to design and backtest the system to give reliable consistent results.

Advantages of Mechanical Systems

The chief advantage of a mechanical system is that it removes emotion by automatically giving the signal. For example, there may be bad news, but if it is already factored into the price the mechanical system will ignore it whereas a novice trader may take a short position, expecting a price drop.

Many traders lose money in the markets because they lack discipline. A mechanical system makes it easier to apply discipline, as all you need is a commitment to follow the system. Sometimes an indicated move is counter intuitive, but the mechanical system looks at what is actually there, not what we believe should be there.

Using a well-defined mechanical system will usually achieve more consistency than a system where the trader makes buying and selling decisions. The consistency is achieved by cutting losses without hesitation as well as by being on the right side of trades, and cutting losses is one of the problem areas for many traders.

Mechanical systems are usually designed to trade with the trend, which is the lower risk method of trading, and they will always let profits run in the event there is a strong trend, and not be tempted to take profits early. A mechanical trader would normally have the trading system backtested using historical data to test the profitability of the rules.

Disadvantages of Mechanical Systems

No system works all the time, and if the market is not showing a trend the mechanical system is likely to produce mediocre results. As markets may trend less than half the time, this is a serious disadvantage.

The best mechanical systems are trend following, and they rely on major trends in the market to make them profitable. If the system cannot recognize the lack of a trend, which most cannot, then money will be wasted by the system trying to trade while the market is moving sideways.

Summary

Mechanical systems are great when it comes to eliminating emotion, which is the downfall of so many traders. They should not be relied upon to trade your account without your intervention, but to take advantage of them you should not intervene on the basis of emotion, but only for rational reasons. It’s an interesting exercise to learn to write expert advisors in your software.

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