Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

MECHANICAL TRADING SYSTEMS, DRAWDOWNS, AND TRADER CONFIDENCE

Mechanical trading systems can prove invaluable in the implementation of the various price risk management tools discussed in this chapter. Because such systems enable us to quantify risk on both a per-asset as well as a portfolio-wide basis, they are essential in the establishment of stop-loss levels, volumetric position sizing limits, and risk/reward estimates. Another, perhaps even more important benefit of mechanical trading systems is their ability to instill trader confidence during periods of equity drawdowns.

Drawdowns in equity under management are a fact of life for all traders. How traders handle these tough times ultimately will determine the degree of success that they and their portfolios will enjoy. A key to successful trading during equity drawdowns is the maintenance of consistency and discipline. Although it is never easy for traders to stick to rules of entry, exit, and risk management after suffering a string of losses, because mechanical trading systems are backtested prior to the commitment of capital, both portfolio managers and the investors they represent should enjoy greater confidence and tempered emotionalism during these inevitable periods of drawdowns in equity.

In fact, it is quite common for asset allocators to dedicate additional funds to a trading system that is in the midst of a sizable equity drawdown. The reasoning here is that if the fund manager maintains a strict, disciplined adherence ...