Two Defining Fundamental Questions

Graybox Trading

Feb 02

The two fundamental and defining questions that all discretionary traders need to ask themselves are:

  1. Why are you trading with discretion when you could be trading a well developed and tested strategy? The answer “it is too difficult or it can’t be done” are not sufficient. You need to know precisely why you are using discretion and what is allowed to be discretionary versus what is defined. I know why I use discretion. But, the question is, do you?
  2. What would it take or how much can you automate, define, backtest, and program? The important realization is that, even if we cannot test everything then we can still probably test somethings. Of course, depending on how critical the discretionary elements are will vary the weight of analysis of such techniques.

Please give these questions some thought before I provide the best answers I could think of:

  1. Implicit learning and pattern recognition. Quick, give me the rules that define how you recognize a dog’s face from a person’s face.  Pattern recognition is one task that people excel at but cannot be easily programmed. Sure, if you took a specific set of images of dog faces and human faces from a specific angle then you could try to generate the rules. But, in general for any rules you come up with we could find examples where they’d be completely wrong. These are the sorts of things that only discretionary traders might be able to do before the advent of deep learning and advanced AI. The implication is that a trader who makes use of these processes will need a lot of examples and a lot of screen time to harness their edge. There is probably a bit of curve fitting going on, as well. As such, the trader needs to be aware of changes that may require new adaptations.
  2. Multi-factor driven decision making. Some discretionary traders are good at keying in on non price factors that drive markets. These source of this information vary and could be sentiment, news, event, or otherwise driven. I often refer to this as a sort of “market cognition” process. A trader with a high market cognition can probably develop many novel strategies if they start to introspect and analyze what they are doing and know about markets.
  3. Speculative, original analysis, and opportunistic. This sort of trader is looking at possible mispricing of future events that could give them a source of edge. This sort of trader might, also, be looking several markets and looking for markets that offer specific qualities for trading. They might, also, be conducting novel original analysis of markets.
  4. Data source problems. It is true that most of the retail trading platforms do not support easy testing of some of the sources of commonly used methods and data that discretionary traders use. These are not usually insurmountable but usually require using either proxy data (and then you have to question if the proxy is sufficient), doing additional development work, and/or buying expensive data.

This post is not meant to discourage discretionary trading. But, we should know precisely what we are doing as discretionary traders while being careful against fooling ourselves about what we are doing. In fact, based on the above list we can identify the likely qualities of more successful discretionary traders and how they are likely to differ from the lesser successful traders.

The following is a list of qualities that will define the lessor successful traders:

  1. Trades a method, mechanically, without an edge in a consistent way. This sort of method/trader won’t survive long and probably defines most indicator traders. Most standard indicators are break even if applied religiously. This sort of trader may be able to do well initially if the regime is supportive of their method.
  2. Trades no method. This sort of trader jumps from method to method (and often market to market) without ever really developing any sort of proficiency or structure. Speculative and opportunistic traders might be at risk and need to be vigilant for signs of style drift.
  3.  Tries to improve a system that has an edge but without appropriate screen time and experience. Many system traders try and fail to improve their systems via discretion. These traders may be trading many products and don’t have a lot of screen time and/or experience. Likewise, many systematic strategies are low frequency meaning the trader would need to increase the frequency of the system and/or develop a structured practice element in order to really test whether or not they could add value.

Final thought, the successful discretionary trader recognizes their strengths and tries to emphasize those strengths while minimizing weaknesses. A speculative trader, who isn’t viewing the market statistically, will want to trade on a lower frequency while a pattern trader probably may need to trader more frequently in order to fully harness their abilities.

About the Author

The author is passionate about markets. He has developed top ranked futures strategies. His core focus is (1) applying machine learning and developing systematic strategies, and (2) solving the toughest problems of discretionary trading by applying quantitative tools, machine learning, and performance discipline. You can contact the author at