Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

PROS AND CONS OF “TRUE” DISCRETION

So far I have addressed only the issue of objectively quantifiable criteria to introduce discretionary overrides for mechanical trading systems as defined by the trading system's backtested results and/or the historical volatility of the assets traded. Once I include quantifiable fundamentals, such as purchasing power parity,¹ sentiment indicators (e.g., put-call ratios, commitment of traders reports, etc.),² and interest rate differentials, or “fuzzy” fundamentals, such as headline news events, the value of including such discretionary overrides becomes somewhat murkier.

This does not mean that the utilization of fuzzier discretionary overrides on a mechanical trading system is without merit. Instead, I am simply pointing out that inclusion of such overrides could call into question the continued validity our trading system's in- and out-of-sample results. Furthermore, once such results are no longer indisputable, risk tolerance measures such as maximum consecutive losses and profit to maximum drawdown ratios also become problematic.

There are and, in all likelihood, there will continue to be obvious moments in which traditional discretionary overrides are prudent performance enhancement tools. While I recognize and freely acknowledge this fact, I merely add a note of caution that once discipline has been overridden without violation of some objectively quantifiable threshold, a dangerous psychological precedent is set in motion. As a result, ...