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New and experienced stock day traders alike grapple with an all important question: Which method is the best approach to stock day trading, a system approach or a discretionary approach? While each approach has its advantages and disadvantages, the correct answer may, in fact, be a combination of the two approaches.
System trading means creating a strict set of objective and mechanical rules for identifying if a trade opportunity exists, when should you enter the trade, and how do you exit the trade. The operative words are "objective" and "mechanical". If a set of trading rules can be programmatically reduced to a series of computer instructions, then the rules are objective and mechanical.
One of the main advantages of system trading is that it enables you to produce consistent trading results. In other words, your actual trading results should be identical to the results generated by the system. This type of trading requires very little thinking or analysis on your part, and all you have to do is follow the trading system rules without deviation.
However, system trading can be difficult to implement in practice because it typically requires you to take all of the valid signals produced by your system in order to allow the system's edge to manifest itself. This is because it may take a considerable amount of trades in order to turn a profit with a mechanical method. As a result, your system will often produce entry signals that run contrary to what your common sense is telling you. For instance, the current trading day may be a very strong bullish trending day without any signs of selling; however, if your system produces a valid short signal, then you must take the signal without question in order to allow the edge to manifest under a system trading approach. Or, if you are in a trade and prices come very close to your profit target and suddenly reverses back toward your entry, you must stay in the trade if your system trading rules require you to do so, even if you believe strongly that the trade is failing. This type of trading is very hard on the emotions because it often requires you to make decisions that go against logic.
Discretionary trading, on the other hand, entails identifying when to enter and exit a trade based on whether you cognitively or intuitively perceive that a profitable trade opportunity exists. In essence. you are assimilating various mental processes of perception and judgment to determine whether you should either take a position or remain on the sidelines. Although discretionary traders also use rules for entering and exiting a trade, usually discretionary rules do not meet the objective and mechanical test. Typically, discretionary rules cannot be completely programmed for computerized instruction. An example of discretionary trading would be deciphering the sequence of trades occurring at the ask versus trades occurring at the bid on time and sales in order to determine whether a trade opportunity exists.
Discretionary trading is usually easier on the emotions than system trading because you tend to take trades that you agree with emotionally. For example, a discretionary trader that trades with the trend and looks for trade entries by reading the time and sales screen would probably avoid taking a short trade during a very bullish trend day in which there were no signs of selling on time and sales, because he would most likely be trading against the trend.
The main disadvantage of discretionary trading is the inconsistent results this style of trading can potentially produce. Markets are constantly changing, and the circumstances and factors which may have led to you placing a winning trade yesterday, may not be the same as they are today. A lot of the success of discretionary traders can be attributed to their ability to perceive trade opportunity. However, what may be perceived as the same setup that occurred in the past, may in fact be an entirely different setup upon a more thorough analysis. As humans, we are susceptible to biases that allow us to equally treat all market situations simply because they look similar to past situations. Looks can be deceiving when it comes to market analysis and one must perform careful due diligence to make sure that they are comparing apples to apples.
There is a third approach to stock day trading which combines both approaches described above. The hybrid trading approach merges together system trading and discretionary trading. Under a hybrid trading approach, you would employ objective system trading rules for those parts of the decision process that will enable you to achieve consistent results, but discretionary decisions would only be allowed for situations that don't materially affect the outcome of the trade. For instance, identifying when a trade opportunity exists and when to enter the trade would be performed under objective system trading rules. However, discretionary decisions regarding how and when to exit the trade would only be allowed after your first profit objective has been satisfied because the essence of the trade opportunity has been met. A hybrid trading approach can often produce more effective results than either a system trading approach or a discretionary approach by relying on the rudimentary idea that sometimes the sum is greater than the parts.
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