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…
