Article by David Pieper, Co-Founder & Systematic Strategies Specialist of Intalcon GmbH
Why we keep falling into the trap
From the outside, stock market trading may not seem complicated: a few clicks are all it takes to participate in market performance or security. However, anyone who has seriously studied the mechanisms of the markets in detail knows that it is a complex and dynamic system. The human brain cannot cope with the flood of information generated. The only way to deal with this information overload and reduce complexity is to use so-called heuristics. Humans consciously and unconsciously rely on numerous rules of thumb that generalize, distort, or completely hide information. The ultimate goal is to achieve a result or make a decision quickly and with little effort.
Discretionary Trading - Flexible but Subjective
The discretionary approach describes a trading style that focuses on the trader's judgment and intuition. It is the individual who continuously observes and analyzes the markets - be it with the help of news, charts or fundamental data. The analysis and derivation of trading decisions is based on rules, which, however, can be applied variably from situation to situation, e.g. by exchanging analysis tools or modifying parameter settings. With this approach, the discretionary trader gains room for maneuver and thus creates the necessary flexibility to adapt to the prevailing market situation. However, this central advantage, which is also used as an argument against systematic trading, has a downside: Especially for less experienced traders, there is a high risk that the different application of trading rules from situation to situation leads to wrong decisions, which have a negative impact on performance. Let's take a look at some of the classic return killers that can be observed among discretionary traders.
traders (like people in general) often overestimate their own performance or knowledge and therefore often tend to take increased risks. The classic: A trader opens a trade with a position size that is far too large, because he is virtually "sure" that this trade will work out. In doing so, he deliberately overrides his money management - usually with disastrous consequences.
The fear factor plays a big role in trading. For example, the fear of losing money. This can show itself in many forms in trading, e.g. that the trader is no longer able to enter new trades after a few losing trades - even if they seem very promising. This fear is also evident in trend following trading, where, for example, positions that are in profit are sold after a small correction, even though the trend continues to point upwards. Paradoxically, the fear of losses can even lead to the fact that no stops are set - according to the motto "as long as the position is not stopped out, it is only book losses". But there is also the fear of missing out on a profit (FOMO, fear of missing out). This leads to traders taking positions that do not follow their trading plan, but are solely due to the fear of missing out. So the greed of missing out on a quick profit goes hand in hand with fear here.
It should be clear to every trader that hoping and praying have no place in trading. In practice, unfortunately, the hope mode can often be observed. For example, long positions that are stuck in an intact downtrend are nevertheless held further or - even worse - enlarged with additional purchases. Why? Because traders are hoping that the discounted entry price will allow for faster profits or at least a break-even exit when a recovery occurs.
Let's summarize: Many of the heuristics we have memorized over evolution are out of place in the modern world - and therefore in financial markets. This is especially true for discretionary trading, because here humans, with all their weaknesses, enjoy (too) much freedom. So there is only one alternative left to tame the Neanderthal in us: systematic trading. In contrast to discretionary trading, the human handing over the decision-making authority to an algorithm in this form of trading.
Systematic Trading - Objective and Emotionless
Trading systematically means trading according to clearly defined, objective rules and following them without question - and without exception. So once a strategy has been established, human emotions have no place in trading. The arguments in favor of the systematic approach cannot be dismissed out of hand:
- People can arrive at different decisions based on the same facts, depending on their physiological state or environmental influences. Algorithms do not have this problem.
- Humans rely on heuristics that are not always sensible or empirically sound. Algorithms, on the other hand, rely solely on facts.
- Humans exhibit overconfidence and overoptimism. Algorithms do not know these states, they do not know emotions and do not possess an ego.
The biggest advantage is clearly on the psychological level: systematic trading offers a high degree of decision-making certainty so that the trader is less susceptible to cognitive errors. By providing clear guidelines for entry and exit, the systematic approach also ensures consistency in trading. In addition, the time required for analysis and decision-making is reduced to a minimum with systematic trading, although it should not be concealed that the development of a trading strategy can take a lot of time.
What does the reality look like?
Despite all the advantages - anyone who has already gained experience with systematic trading of securities should confirm that this trading style is not completely free of emotions either. They still exist, just in a different form. Thus, our expectations and emotions already flow into the development and testing of a trading strategy. But the biggest influence is during the implementation of the strategy itself. The following examples describe typical situations where systematic traders sooner or later come into conflict with their emotions.
Live implementation of the trading strategy after demo trading
After the development and validation of one's trading strategy, a demo trading phase follows before the start of live trading. Here, all trades specified by the trading strategy are implemented in the demo account - and thus risk-free. After completing a certain number of trades, the trader is faced with the decision of when exactly he wants to "arm" the strategy. And this is where emotions already come into play. Let's imagine that the strategy is in a steep uptrend. Should we start right away, even though a weak phase would be anything but surprising? Or does it perhaps make sense to wait a little longer and start trading the strategy only after a losing phase? A classic case of uncertainty and thus a gateway for subjective decisions.
Strong profit phase vs. position size
Another situation, which at first sounds anything but problematic, is given when the traded strategy is crowned with success and thus makes the account jump from high to high. The longer this condition lasts, the greater the temptation to increase the position size. So, even though everything was set hair-trigger in the backtest - the greed for higher returns can have a very strong impact on the emotion state of the systematic trader and cause wrong decisions.
Omitting trading signals
The benefits of systematic trading only come into play when the trader follows his system, without exception. However, during extreme market movements in the context of important events, this imperative is difficult to adhere to. Thus, in such situations, traders are often inclined to follow their feelings and stay away from the market out of fear. So instead of following the set of rules one-to-one, they instead try to intervene in the mechanical system in a discretionary way in order to generate (supposedly) better results. However, especially in trend following strategies, whose profits are often based on a few highly profitable trades, the omission of individual trades can have fatal consequences for performance.
Anticipation of trades
Imagine that you have a trading strategy that specifies a certain entry, e.g. at the end of the trade when the current candle closes positive. Every now and then, even in these situations, the systematic trader falls into the emotional trap of trying to anticipate the entry in order to "squeeze out" a few more points. Another example in this category can be observed in stop management. Imagine you place a long trade and a little later negative news causes the market to plunge, VOLA increases massively. Although the systematic trader knows that he must trust his set of rules and that he should not intervene, the temptation here is to take the current trade out of the running prematurely or to tighten the specified stop in order to reduce the losses of the position - which are anticipated in the mind, so to speak. In both cases, the trader is not really aware of the fact that he is interfering with his actual trading strategy, because he is convinced that he is contributing his "additional knowledge" for the benefit of performance. It is exactly these well-intentioned interventions that usually destroy the performance and incidentally fuel the old cycle of uncertainty, mistrust and renewed discretionary interventions.
A typical situation where systematic traders come into conflict with their emotions concerns the shutdown of a trading strategy after a drawdown phase. Let's imagine that a trading strategy has been producing solid and stable results for months or even years. A violent drawdown phase begins and the capital curve slides massively downwards - a new experience for the trader who is used to success (see Figure 3 on the left). Exactly at this point, there is a high risk of prematurely shutting down the trading strategy for fear of further losses. Alternatively, the systematic trader might feel forced to readjust the parameters of the strategy in order to bring it back "on track for success". Both decisions carry a high potential for error due to the uncertainty involved, which in turn arouses emotions in the trader.
Monitor emotions, control actions
As long as the flesh-and-blood trader has to make decisions, such as how to handle drawdowns, certain emotions will remain in play. So whether acting as a discretionary or systematic trader, discipline remains the key to success. Therefore, in order to be able to identify detrimental behaviors, traders should always keep an eye on their emotions and be actively aware of them instead of ignoring or suppressing them. The emotion itself cannot be controlled, but the action can. Clear trading rules can therefore provide valuable services here, as well as the parallel trading of several trading strategies offers an advantage for systematic traders: Due to the increasing complexity in the implementation of the signals, it becomes all the more difficult for the trader not to adhere to the exact rules - a simple, disciplining measure. The choice of position size also offers an important psychological adjusting screw: as long as the trader feels nervousness or anxiety, it should be further reduced to reduce emotions and at the same time increase discipline. However, there is one thing we must come to terms with Trading without emotions is not possible.