Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

DISCRETION AND PARADIGM SHIFTS

Although there is no objective answer to the question of what constitutes a paradigm shift in market dynamics, for the purposes of this book I will define the phenomenon as a permanent or long-term shift in market behavior that greatly diminishes the viability of historically robust trading models. In Chapter 7, I presented an example of a paradigm shift through the comparison of Figures 7.1 and 7.2, which illustrated a collapse in the performance of the 20-day channel breakout system for IGBPUSD (British pound-U.S. dollar) from 1993 to 2002 versus 1983 to 2002.

When faced with paradigm shifts, mechanically generated trading signals could (depending on the size of system stop-loss levels employed) result in the termination of a system trader's career. Recognition of the potential severity of this problem has led to the establishment of some possible thresholds for the introduction of a discretionary overlay to the implementation of mechanical trading systems.

Some of these potential thresholds are, in fact, objectively quantifiable (and therefore mechanical) and were alluded to in Chapter 8. They include exceeding the maximum number of consecutive losses experienced by the system during its backtested history and exceeding of the system's worst peak-to-valley equity drawdown and stop-loss levels for trading systems. In such instances, a prudent discretionary course of action probably would entail suspending execution of signals generated by the trading ...