Discretionary traders use intuition
The discretionary trader has more opportunity, per se, to acquire a more intuitive feeling of the market since he must analyze it regularly.
Under a given set of circumstances, it is said, this will result in a better understanding of how it operates.
Yet an essential argument for quantitative trading, and against discretionary trading, is the psychological element that is inherent in discretionary trading. Discretionary trading is not beholden to analysis thus runs the risk of biases, lack of discipline, and other psychological short-comings.
Thinking Fast and Slow
In his book Thinking, Fast, and Slow, author Daniel Kahneman explains that the human mind employs two distinctly different methods of thinking at the same time. When it comes to trading, these different ways of thinking often oppose each other. Ignorance of their existence can explain why humans are not good traders. Daniel Kahneman and Amos Tversky won the Nobel Prize for the “Prospect Theory” that uses cognitive psychology to study how people manage risk and uncertainty.
Their findings are highly important in financial economics and reveal the weaknesses of us humans in investment decision-making.
“Experts are uniformly inferior to algorithms in every domain that has a significant degree of uncertainty or unpredictability, ranging from deciding winners in football games to predicting longevity of cancer patients. One has to accept financial markets are no exception to the rule.” Daniel Kahneman
System 1 and System 2
Kahneman refers to these two types of thinking as System 1 and System 2. System 1 thinking is described as “fast, automatic, frequent, emotional, stereotypical, subconscious. ” System 2 as “slow, effortful, infrequent, logical, calculating, and conscious.”
System 1 relies on intuition and assumptions. In the trading world, this is called discretionary trading. Properly harnessed intuition can be a tremendous asset. Improperly harnessed intuition can lead to overconfidence, isolation, and the creation of confirmation bias which leads to statistical errors.
When people create a cognitive bias, they develop a tendency to only believe supporting arguments while ignoring valid points to the contrary. Traders can then refuse to follow the rules by simply not acknowledging evidence that could have saved them a lot of money.
Traders must be disciplined enough to stick to predefined rules when a position does not move in an expected way. Unfortunately, natural human tendency operates under the overconfidence of System 1.
Another disadvantage is a discretionary trader relies upon his/her own analysis. Not a set of automatically generated buy/sell decisions. This will limit the number of markets that can be traded. Whereas a mechanical trader can apply criteria to a wide array of markets.
“The universe of trading systems is divided into two – having confidence and having faith. If you want quantifiable confidence, the kind of confidence that tells you whether or not to hit soft 17 at blackjack, whether or not to hit the blot in your inner table in backgammon, or whether or not buy a new 52 week high – use quantitative analysis. Everything else is faith.” Howard Bandy
Quant traders use a model
Quant trading uses a fixed set of rules to determine trade timing and direction in a systematic way. The same scientific parameters do not confine the discretionary trader.
Instead, discretionary traders use intuition and “market feel” in order to make technical decisions. Outside emotional influences continuously bombard the human mind. When discretionary traders want a certain outcome, situational influences can result in the exact opposite. Its called “mind sabotage.”
The discretionary trader does not always make the same interpretation of a market indicator (chart, technical study, fundamental information, etc.) or use it, in the same way, each time it’s applied. This trader uses personal judgment to determine the value of that indicator at any given point in time.
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