Part 2 - Mechanical:
The dictionary definition of mechanical reads: "like a machine, as if acting or doing without conscious thought."

Unlike the discretionary trader, a mechanical trader uses a set of unambiguous rules to guide his or her actions in the market. These rules determine:
o when to buy and sell
o what to buy and sell
o how much money to put into a particular trade at any given time

This means that mechanical traders do not use judgment about when or what to buy and sell and how much to invest in each trade—they act on their established rules without consciously judging the rules or the situation that is signalled by their rules in any way.

If you do not use an unambiguous set of rules for your trading decisions, you are, by definition, a discretionary trader. The majority of traders in markets around the world are by definition discretionary traders. Just about every trader starts out being a discretionary trader. They just don’t see themselves categorised as one because they are unaware of the context of their actions in the trading arena as compared to a mechanical trader.

With the discussion on market variables last week, hopefully you are beginning to realise how badly the odds are stacked against them making money in the markets.

How do you know whether the edge, discretionary or mechanical, is indeed an edge? Most traders do not work this out. Or with great difficulty they eventually work it out after they have done many trades. However, the key is to know this before you actually start risking money in the market. You are not alone if you don’t—very few actually do this before they start trading.

Knowing whether you have an edge or not requires some basic statistical analysis knowledge and knowledge on probabilities. This has been discussed in previous blogs.

The less you have been exposed to trading in your youth until your early 20s, the more important it is that you go down the mechanical path to achieve the goal of becoming profitable on a consistent basis.

In fact, the majority of human beings need to go down the mechanical path to achieve success in the markets. The fact that few do is one of the main reasons why more than 90% of traders close their trading accounts with less money than when their accounts were opened. Simply put, over 90% of traders lose money!

The need for a mechanical step to learn to execute trades at a level that generates profits on a sustained basis is no different to just about everything else that we have learnt in life. Take another mental process like reading. We all needed to go through the mechanical step to learn to read whether it be using a phonetic technique or otherwise. Similarly with physical learning processes like writing, riding a bike and driving a motor car. Trading is no different.

Mechanical trading criteria emanate from the market through rigorous research. Therefore the unambiguous criteria used to enter or exit trades come from a market paradigm. If these criteria have a proven edge then you, the trader, can trade profitably over a large sample of trades by executing the mechanical edge, if you don’t get in the way of the edge.

If you are not using mechanical criteria based on market price action then you are using a paradigm that emanates from a non-market environment, like a societal paradigm. The experiences that we are programmed with for surviving in society will not stand us in good stead in the environment of the market. You have an edge for surviving or flourishing in society, not for surviving or flourishing in the market. You need an edge that emanates from the market. This is what a mechanical edge is.

Part 1 - Discretionary:
Discretion is defined as: "freedom or authority to act according to one's judgment".

Statistically most investors use discretionary decision making processes in the market rather than mechanical processes. Unfortunately, very few discretionary traders have longevity in the market and hence you could conclude that they don't have an edge.

A discretionary edge is dependent on your judgment of market conditions and/or of the particular trade you are analysing. Your judgment is based on your historical experiences and knowledge attained to date, computed against all the input at any given moment. These include perceptions, beliefs and life experiences.

Your perceptions are determined by the beliefs you have at any given time regarding what you are focused on at that time-that is, what your radar is capable of picking up. Your beliefs are determined by all the experiences and knowledge which have touched your life to that point of time. Meanwhile, your experiences to date will always be a subset of all the experiences that you could have experienced up to that given point in your life.

However, the input variables that you can perceive at any given moment will always be limited to a subset of all the variables that can affect any given judgment at any given time. There are always more variables at play around us than our senses can pick up.

At the end of the day, your judgment is who you are. Your judgment is played out through everything you think, feel, say or do. Hence it defines the way you interact with the world around you whether it is as a spouse, mother, father, son, doctor, engineer, tennis player, golfer, friend, colleague, leader, manager, trader, etc.

Your judgment will determine the level of success you achieve in any of these roles and what opportunities you take that lie before you. Whatever success or failure you have had to date in any of these roles is a measure of your judgment in that particular role. For your discretionary judgment in any walk of life to provide an edge requires multiple years of formal training in the mechanics or theory of what you do and then many years of
experiences to program your brain in terms of that role.

It gets even more complex because human beings are incapable of calling on all their experiences and knowledge at any given time to make a judgment. This means that, given exactly the same input on two different occasions, with our knowledge bank at exactly the same level, our judgment can be vastly different. This is how our brain works.

Ask yourself, how well is your judgment attuned to the market? You can answer this right now. If you have lost considerable money, then your judgment is very poor. If you have not made any money then your trading judgment is poor. If your trading performance has delivered profits but much less than the compounded annual return of the overall market index you are better than the loser. Still you are worse off than if you had invested your money with a managed fund and not bothered to trade. Bear in mind that most managed funds under-perform the overall index and only a minority do better. If you have consistently outperformed the overall market index then your judgment is well attuned to the market.

If you wish to improve your performance you need to change something about your ability to make judgments in the market. For a discretionary trader, this means changing who you are as a person. Further, this means that you have to step into a process that changes the way you go about trading. To change the way you go about your judgmental trading, you need to change the way that you think. The pathway is to use a process that involves becoming a successful mechanical trader first, then returning to try to be a successful discretionary trader, if necessary. We'll discuss mechanical next week.

In this, my final posting on this topic, I respond to Victor's comment posted in response to my 28 May Blog. At first glance this blog may appear complex but the area of risk management and money management is an extremely important area of active investing so persevere to understand it well. Hopefully Blog readers will get a better understanding why generic money management methods don't necessarily work at a practical level for all types of stocks/instruments unless they are tailored to your requirements.

"Hi Gary

My understanding of how stops should be set is this:

The placement of the initial stop SHOULD BE DETERMINED BY THE BEHAVIOUR OF THE STOCK. i.e. at a line of support (need to eyeball the chart), at an ATR multiple away from the entry, on a moving average etc.

The gap between the stop and the entry then DETERMINES THE POSITION SIZE. ie the max dollar risk per trade (be it 1%, 2% of portfolio value) is divided by the gap to give the number of shares for that position. This way more volatile stocks, with larger gap between entry & stop, will end up with lower position size ( in dollar terms), and low volatility stocks with small gap will have a larger position sizes ( in dollar terms).

This is similar to spa's low med high entry risk system.

Whether it is any better than spa over the long term I have no idea because I haven,t done 10,000 hours of research because I am not 500 years old. But If I do use stops, the above method is how I go about it. "

This is one of the most popularly written about methods of position sizing and risk management. It is far better using this method than using nothing at all or using a simple 10% per position in a portfolio. This is so because it is based on determining a technical exit position as determined by price action in the market and then working backwards to determine a position size which is interlinked with the technical exit rather than treating all stocks the same. Either the maximum dollar loss or the technical exit will ensure that the trade is exited, provided the active investor follows their rules and executes the exit.

As Victor states, the active investor will need to determine how the technical exit is determined. May I suggest that a consistent and objective method is used (rather than eyeballing) that you know works for the timeframe in which you wish to trade. To know it works you might need to do some backtesting. Hey, that sounds like determining a mechanical technical exit!!

However, the method suggested by Victor can have some problems that need to be highlighted and solved by the trader:

1. The choice of support level can be subjective and will be different depending on the trading horizon (short, medium or long term) and the technical analysis skill of the active investor. The moment subjectivity comes into the equation there is potential to change the criteria mid-trade, which is NOT a good thing, or to get it wrong by taking too much or too little risk on a consistent basis.

2. Using volatility based position sizing, i.e. "an ATR multiple away from the entry", really only works practically for a small number of stocks on the market because nearly all the position sizes derived from this method would exceed the maximum of 20% of portfolio value that you should place in a single trade for any given portfolio. It really only works for highly volatile stocks with sufficient liquidity. Even then, what ATR multiple do you use? Traders trying to use this method usually solve this problem by adjusting the ATR multiple for different stocks which defeats the object of the method because the idea behind it is to allow the varying volatility (measured by ATR) to automatically adjust the distance to the stop level.

Let’s look at a couple of examples. To make the arithmetic easy to follow let's assume a $100,000 portfolio and 2% max risked per trade, or $2,000, and exclude brokerage. Also, let me state another very important money management rule which is widely used to limit risk of portfolio ruin. This is the maximum position size for a portfolio and is set at 20% of portfolio value. Some may raise this to 25% which I believe is too high.

Example 1
Take a stock that has an ATR (15) of 46.5c and is priced at $23.20. The ATR of 46.5c as a percentage of stock price is around 2% which is where most large cap stocks will trade for months, or even years, on end, especially in bull markets, making this a very representative example.

2xATR ($0.93) to 3xATR ($1.395) are the most spoken and written about levels of setting a volatility technical stop loss which would be $22.27 and $21.80, respectively, in our example.

At first glance this looks quite OK. Now let's calculate the position size using the most discussed and written about '2% rule'. $2,000 / 0.93 = 2150 shares * $23.20 = $49, 880. Oops, 50% of portfolio value and way too big! Ok, let's try 3xATR. $2,000 / $1.395 = 1434 shares * $23.20 = $33,268.80. Still too big!! In fact to get a position size that is below the maximum position size of 20% of portfolio value you would need to use 5xATR and that would be just below 20% of portfolio value so you really would need to use at least 6xATR to get a small enough position size to allow for some growth in the position. 6xATR is $2.79 or 12% below the entry price.

To get a more realistic position size for stocks of around 2% volatility you might consider using the 1% max risked per trade just to get a position size that isn't too big. This would allow a realistic position size down to 2.75xATR.

So where was the support and resistance technical exit for this example? A reasonable medium term support and resistance technical exit for this example based on a recent weekly low would have been $21.70 or $1.50 below the entry price. Let's try this with the 2% rule. $2,000 / $1.50 = 1333 shares * $23.20 = $30,933. Too big. So we'll have to use the 1.1% rule for this one to get a position size of around $17,000 which would allow room for a 17% profit before the open position approaches the 20% of portfolio value level.

Hopefully you can see that the single biggest determination of the final choice is what a reasonable position size is relative to the maximum position size allowable for the portfolio.

Example 2
For the second example let's look at a more volatile stock such as Extract (EXT). The SPA3 entry signal occurred on 24/12/09 at $1.26 and the ATR (15) was 6.3c, or 5% volatility, which is relatively high. The short term and medium term support and resistance levels would be at $1.10 and $1.00, respectively. These is my subjective 'eyeball' opinion and is, hence, very debatable.

Let's do the arithmetic. 2xATR $2,000 / $0.126 = 15870 shares *$1.26 = $19,996. This is too large so 2.5xATR with a position size of $16,000 would work better allowing headroom for growth of a high volatility stock. However, 16% of portfolio value is too big for my liking for a stock with these characteristics and would be a far larger position size than SPA3 would allow so you would probably need to use a 3xATR, 3.5xATR or 4xATR.

There are another two important considerations that these position sizing and risk management techniques don't take into account:

1. Liquidity Risk. What if the position size is too big for the traded value that a stock is actually trading? For example, the calculations above provide a position size of $15,000 but the stock only averages $70,000 traded value per day on average. A trader's rules must account for these too.

2. Market Risk. Position sizes should not be the same size in falling markets as they are in rising markets. To adjust for market risk is the ATR multiple changed and / or is the max risked per trade adjusted? What technical criteria are used to determine a rising and a falling market to determine when the position sizing calculation changes?

Conclusion for the last 3 week's Blog postings
So what % rule for max risked per trade do you use and what technical exit rule do you use with which stocks and in different market conditions? Is it based on the percentage volatility of the stock, support & resistance or other technical patterns or indicators? I suggest that at the practical level the method discussed in this Blog is not as simple as the two or three pages that most books devote to the topic merely pointing out the formulae. I'm not saying that it is wrong, just that there are many more complexities to the method than most discuss or implement.

Financial Stop Losses and associated position sizing was one of the most debated sections of the course material amongst attendees in the SPA3 Training Classes that we used to run in the early 2000's. Many years on it seems that nothing has changed!!

When you have a mechanical trading system, working out the risk management and money management is a far simpler exercise because you know the boundaries of the raw edge. All three components are intertwined and the existence of a mechanical exit system is the biggest simplifier.

Every system needs it own risk and money management that is tailored to the system depending on the objectives of the system, the time frame for the hold period of trades, the instruments that are traded and the risk profile of the trader that trades the system. Because this is tough stuff to work out traders gravitate to generic methods and accept them as the only truth without investigating the detailed practicalities of the method. I have no problem with not re-inventing the wheel but the boundaries must be determined of the exit and position sizing regime that is used and the generic method should be tailored according to the objectives of the trader and the trader's system. And most of all, the money management and risk management system should work at the practical level, not just the theoretical level.

Response to Comment by Thomas Rac:

"as you are using technichal exit signal only as to exit a stock what is your interpretation of that valid signal.bear in mind that any particular stock might go temporary for a breather even 10 or more percent but you still would not know the outcome and sustained a huge loses if it was a biggening of a down turn."
To read the full comment click here.

Firstly, using a mechanical system is done to eliminate interpretation. I do this because I acknowledge and accept with every part of my being that human interpretation is done through a biased spectrum that is also not able to comprehend all the variables that interplay with any stock's price in the markets. Therefore, I can never know what will happen in the future. In fact, "anything can happen."

Secondly, you must allow a stock price room to breath. A technical stop allows it room to breath based on it’s individual price characteristics and not on your portfolio or risk profile, both of which have no influence on the market and are not determined by the market.

Each and every situation is unique therefore how much it needs to "breath" for each situation will be unique and hence different. This means that you will never know with certainty in realtime whether a retracement of any kind is just the trend unfolding or whether it is the beginning of a reversal of trend. You will know many weeks or months later with the benefit of hindight.

What is important is that you use a logical concept, research it and ensure that it provides an edge when combined with the entry criteria. Then execute that logical concept flawlessly knowing and accepting that it will not be right every time but that over a large sample you will be way ahead by adhereing to it.

To find two examples where a 2% TSL would not have worked well I looked at the two biggest profit trades that we have done in the SPA3 public portfolio in recent times. These are EXT (Extract Resources) and LNC (Linc Energy), 231% and a 199% profit trades, inclusive of brokerage, respectively. EXT added $20,097 and LNC added $22,945 to the portfolio.

Using a 2% TSL the EXT trade would have been stopped out with a 5% profit trade or just $436 absolute profit. The LNC trade would have been stopped out with a 7.34% profit trade or just $845 absolute profit.

Both these trades traded below their 2% TSL for 4 trading days before continuing their trend.

For an example of a 2% ISL, the 4th biggest trade in our public portfolio, MMX, could have been stopped out depending on the entry price into the trade (on a large range day) between $1.70 & $1.57. We use the close which was $1.595 but an entry at or above $1.62 would have resulted in exiting the day after the entry at a -13% loss or -$1,000. In any case, a 2% TSL would have limited this eventual 195% (or $24,973 absolute) profit trade to just 28% profit.

For the record the biggest % mover, 291%, over the 8 years from the SPA3 public portfolio, AUM (now CDU), could also have been stopped out at a loss the day after entry if entry had been at 61c to 62c instead of 60.5c.

There are plenty more examples. It's been years since I did this reseach and spending a few hours looking at many recent examples in up and down markets has re-confirmed my views. Thank you for the opportunity through your posting.

IMHO the 2% rule is too close for medium term trading however this is a useless statement unless you have an alternative arrived at through research. Having said that, it's far better using it than nothing at all.

Regards

Gary

Response to Comment by Leigh:

"If a stock is allowed to drop an exceptionally large amount (the size of the % drop is of course subjective), then it has already proved itself a pretty poor choice if not a "loser" and hanging on to it is "living in hope" that one might miss it's possible turnaround."
To read the full comment click here.

I absolutley agree with your statement. It is natural for a stock to retrace and by how much should not be determined using a subjective method. Having an unambiguous exit strategy is not living in hope, it is trading objectively.

Every stock will behave differently and every stock's future is unique. With SPA3, a fall in price will always trigger a technical exit at some stage, at which time you look for other opportunities.

"For example SPA 1 portfolio (I stand to be corrected if I am wrong) had 8 stocks losing more than 30%, the largest loss being PVA @ 47.83%."

You are correct, there have been 8 trades in the SPA3 public portfolio that have lost more than 30%. To put that into perspective, this is 8 from 831 which is 0.96% (i.e. less than 1%) of all closed trades. A poor system designer might introduce a rule to eliminate 30% or worse loss trades but I can guarantee you that the same introduced rule would also eliminate a whole lot of profit trades that the system would otherwise have achieved.

There have been 2 that have lost more than 40%, PVA and BKN (I did the BKN trade in my Super portfolio but also did the next one which was a profitable trade). PVA was suspended for a few days and dropped on the open after suspension and BKN opened down over 40% on an overnight announcement from an up trend. Neither of these could have been prevented with an intraday financial stop.

As I keep saying, "anything can happen" and there are too many variables to eliminate all bad outcomes.

"I don't know what would generally be regarded as an acceptable max % loss by others, but I guess I would be feeling uncomfortable at anything greater than 25% and perhaps comfortable at 20% as an over_riding exit to technical analysis stops.

Convince me I'm wrong!"

I can only use research to try to convince you that you may be heading down the wrong track. You see, by introducing any rule to your trading system you can't focus on the positives that it will bring to the system without measuring what the negative affect to the system will be.

Let's first see what you are trying to avoid. There have been 21 trades in the SPA3 public portfolio worse than a 25% loss, that is, 2.5% or all the 831 trades and 50 worse than a 20% loss, or 6.02% of all 831 trades.

Of the trades mentioned above LNC, MMX and AUM would have been stopped out well before the SPA3 exits (LNC early in the trend) with 20% trailing stops. These are only a few of the trades that form part of the profit side of the system. Out of the 831 closed trades, 89 have had greater than 20% return, 38 greater than 50% return, 13 greater than 100% return and 2 greater than 200% return. How many of these would have been stopped out with a TSL?

The above discussion really is redundant because the SPA3 edge proves that with the existing entry and exit mechanisms, risk management and money management rules it massively outperforms the market, managed funds and portfolio managers.

Losing is a natural part of trading and it must be accepted.

Regards

Gary