Updated from its original posting on 11-03-2011
For those who aren’t comfortable with purely mechanical systems or those who get carried away by their emotions in using a 100% discretionary approach, a hybrid trading style could work better for you. If applied properly, this type of trading can combine the best of both worlds and be a better way to trade for you.
What’s the difference between a mechanical and discretionary trading style anyway?
A purely mechanical system requires the trader to trust a system of signals based on price based indicators to give valid entry/exit points to produce profits over the long run. Since all you have to do is wait for a valid signal and take the trade, using a mechanical system can eliminate the psychological aspect (fear and greed) out of your trading decision. While trading emotion free can be great, the downside is that there will be times when the mechanical system gives trade signals that don’t jive with the current fundamental bias or market environment.
On the other hand, a purely discretionary trading approach involves taking trades based on where your own analysis of fundamentals, price action, or risk sentiment. While this type of trading takes the current market environment into account, it could to lead to inconsistent results when applied by a trader easily influenced by emotions and/or personal biases.
How can a hybrid trading approach solve all that?
Hybrid trading combines the objective trading rules of a mechanical system with discretionary decisions of the trader based on dominant market themes, current risk sentiment, price action, and recent economic events.
The advantage of using a hybrid system is that the system is developed on your understanding of the market and YOUR trading personality. Ideally, the system will incorporate the indicators and parameters that you are most comfortable with and intuitively understand.
By using a hybrid system, you can choose to take the trades that make the most sense. Remember that one drawback of taking a purely mechanical system is that it cannot distinguish between changing market environments.
Let’s say that the market has been ranging lately and you get a signal to go short. However, your system is a trend-following system and you feel that if you take the signal, you are just going to get chopped up. By incorporating a hybrid system, you can use your ability to adapt to the current market conditions to override the signal, therefore enhancing your system and avoiding possible losses.
Be careful though, as this is where it can be very tricky. If one were to simply override all the trade signals without any basis (like past price action), then what would be the point of having a system at all? Always keep in mind that the subjective part of a hybrid system is meant to compliment the system’s trading rules in order to maximize profits – not to ignore it completely!
Hmm, that sounds doable. So where do I start?
As tricky as the hybrid system can be, the preparation needed is pretty simple.
You can begin by keeping a record of how price reacted to news reports, different market themes, and market structures. Documenting price action might be tedious and labor-intensive at first, but with A LOT of deliberate practice, it will help you develop a knack for spotting similar setups in the future. After all, the phrase “history repeats itself” didn’t become famous for no reason.
Of course, identifying similar setups is only half the battle. Since you’re combining mechanical AND discretionary trading, you also need to practice the subjective part of your decision-making.
One good way of preparing is by asking questions like “Is market environment the same as the past setup that I recorded? What will I do if price doesn’t react the same way?” By verifying your discretion with past price action, you can increase the probability of making good trade decisions with your hybrid trading approach.