A Look At Mechanical and Discretionary Forex Trading

Forex trading, much like many other forms of financial market participation, is typically carried out using one of two approaches: mechanical or discretionary. In the mechanical approach, one relies on application of technical analysis to generate trade signals, and this is done in a centralex very systematic manner. While in discretionary trading, the trader leverages his/her experience in the markets to sieve and assess opportunities. There is an element of human judgment here.

Is one trading approach superior to the other? How do you decide which one to choose? Let’s have a look at the good and bad of each approach and consider what selection criteria should be applied in each case.

** Mechanical Trading Approach **

1. A mechanical Forex approach has many advantages. Here, a trader follows very strict rules for trading, which keeps him/her in control to avoid emotional trading. There is no guess work, as it is very clear cut whether a trade should be entered or exited.

2. Mechanical trading derives trade signals from a system using primarily historical Forex trade data. Since Forex strategies formulated this way can be accurately back-tested with performance statistics to boot, this is seen as beneficial. Additionally, a mechanical approach lends itself well to automated Forex trading — the trader can do Forex trading in the background via automatic system-generated trades sent direct to the broker.

3. The main disadvantage of a mechanical trading approach is its inability to react to and follow new market conditions. As historical data is always biased to prior market conditions, even if the system statistics show favorable performance there is no guarantee the system will continue to produce Forex profits in the present or future. Worse, the system can be tweaked to optimize performance statistics, which may create an illusion it works extremely well.

** Discretionary Trading Approach **

1. Discretionary trading leverages a trader’s experience in the Forex markets, which can be an advantage as the trader is able to pick higher probability trade opportunities and disregard the mediocre ones. Since a human makes the trade decisions, changing and new market conditions can be embraced quickly and adjustments made to the trading approach.

2. However, the human factor in the discretionary Forex approach can also be regarded as a disadvantage. It takes many years to build the necessary Forex trading skills and experience, and most probably also a few accounts blown. Not many traders can trade without emotion when money is at stake. The fact that the system is not rigid also means the Forex trader can be influenced by hindsight to change trading rules arbitrarily. Lastly, trade automation is not feasible since a human is required to make a decision on every trade setup and when to exit trades.

Before you go ahead with either approaches, review first you perform as a Forex trader. Do you hesitate to act on your trade setups? Are you the sort that keeps moving stop losses as trades play out? Does being in a trade often evoke elements of fear, greed and anger? Perhaps a mechanical approach would fit you as it can alleviate most of these problems.

What if you have a special ability to hit home runs under certain market conditions? Or if you can “tell” that a trade setup might fail to work in a particular situation? And you are very disciplined and also emotionless when trading? Well, discretionary Forex trading may suit you better since you are in control and abnormal profits (compared to mechanical trading) can sometimes be had.

Finally, there is also the option of mixing both approaches to make a hybrid one. Consider taking the advantage of Forex trade automation from mechanical trading, so that you get trade evaluation and order entry covered. Slap on the option of human intervention to allow non-performing trades to be closed early, new trades to be scaled in, and finer adjustments of target prices. This is like a best-of-both-worlds system and is perhaps the best choice for some Forex traders.

Whichever trading approach you select, there are a few must-do rules to follow. Always know your risk before each trade, not trade a setup first and evaluate risk afterwards. Always use correct position sizing for proper risk and money management, so that you protect your trading capital. And do give time for the system to perform.