Trading the trend: Rules-based and discretionary strategies

It is an oft-debated in trading circles whether rules-based trading strategies are better than discretionary trading strategies. 

In my view both have their advantages and disadvantages. For rules-based trading strategies these can be set up ready to execute at certain programmed points. It means that we do not have trades forgotten about but more importantly we take out a lot of the emotion in trading.

Emotion is the reason for many private investor and retail trader downfalls. The struggle to control emotions causes chaos. This is because we are innately primed to search for rewards. And when we are focused on rewards, we are not necessarily focused on the risk. 

Investors focus on the potential upside on a stock and can become entranced by it, dreaming and calculating of the money they will make when the stock achieves that target price. But what is not calculated is the risk. This is where it becomes tricky, because when one is absolutely convinced that the stock will go up, it then becomes illogical to define the risks. To do so would be to do something that you are convinced won’t happen. And why would anyone do that?

This is where rules kick in. By having set risk principles in advance we remove this bias and sell based on pre-determined parameters. For example, if we decide on our exit strategy both to the upside and the downside before we even put the trade on, we are removing emotional investment in the stock and calculating this from a position of objectivity. 

Objectivity is lost as soon as we press the buy button. Once we have a position, we then have a capital investment and an emotional investment into the stock. So, to set our exit strategies once we’ve pressed buy would be to do so at sub-optimal conditions. So far, this may seem like simple stuff. But often the simple stuff is not done. Common sense isn’t actually all that common. I get emails from people asking me what I think of certain stocks, and as I can’t and don’t offer advice I ask them what their stop loss was. 

Often, they’ll tell me they didn’t have one, and they were thinking about buying more. Even though the single piece of feedback that they had received from the market was that the stock was a dud and it was falling, rather than sell they were considering taking on more risk and buying more shares. 

We’ve all done this before – at least I have. It is human nature to be loss-averse but the act of committing more capital to a falling stock is taking on more risk. 

Logically, if we were to buy an expensive cheesecake from the supermarket and it tasted disgusting then we would throw it in the bin. We wouldn’t continue to eat it. We would cut our losses. But shares present unique psychological challenges that will continue to blight us all.

I believe in rules. Rules keep us safe. I have rules for position sizing, entries and exits, managing winners, and checklists to keep me on top of what I should be doing. Rules based strategies are far less stressful and less likely to blow up.

However, discretion is where we have the opportunity to seriously outperform. The UK stock market is inefficient and sometimes illiquid. Finding special situations that the market doesn’t seem to value can turbocharge a trading account. This – I suspect – is why so many people love buying and selling shares. It is fundamentally a game of skill, but there is enough luck (we can manage the downside and keep risk to the upside) involved to keep people excited. Most private investors underperform the market, when they could buy passive index tracker funds and do much less work. But that doesn’t stop many from trying. And communities like Stockopedia and Twitter certainly help.

Xaar

One stock I have now bought is Xaar. This is one I’ve traded several times over the last few months as it has been a good one to buy and immediately put onto the book up for sale. However, the chart now looks like it is a solid uptrending stage 2 stock. 

Here’s the chart looking back the past several years. 

In 2018 the stock was trading around 400p. But let’s go back further.

We can see that in 2014 the stock was a lofty 1200p. Another mistake that people tend to make is that of discounting. Because the stock was 1200p previously therefore at 110p it must be cheap, but that is discounting all of the reasons that the stock is now trading at 110p. I have no idea if the stock is cheap or not but the chart now looks healthy.

One thing we can see is that from February volume increased yet this volume trend has continued into the rally. This shows accumulation and Andy Brough of Schroders now owns not far from a third of the company. The directors were also heavy buyers much lower in size. There is talk of change in the recent interim results which also bodes well.

It could be that Xaar (LON:XAR) is forming a cup and handle around the 110p area. We saw a brief sell-off on the results only for the stock to rebound strongly. I have been a buyer post-results and I’m looking to capture a stage 2 trend here. For now, I am giving the stock breathing space and will average up into the position once I am sure the trend has now properly turned. It is much safer to do this than pile in now and risk getting stopped out with a stop that is too tight. 

You can download your copies of Michael’s books at www.shiftingshares.com

Twitter: @shiftingshares