Trading Strategies: Man or Machine?

Investing is an emotional business. Many argue that setting aside our human-ness can be the best ally against making ill-fated investment decisions. And, while in many facets of life turning to machines to make decisions might not be the best idea (computer generated greeting cards come to mind), in the case of securities trading the practice has come to the forefront. An article in the July issue of Proactive Advisor magazine argues that, while perceived as “cold” by some, machine-driven trading can be a highly successful method of active investment management.

“Mechanical” trading strategies are those that are based on a clearly defined set of rules, yet devoid of discretion or interpretation. This includes the selection of securities, when to buy or sell, and how much money to put in each position.

The differences between the two strategies can be best explained using the four stages of a trading strategy’s life cycle:

trading cycle

Source: Statis Trade

  • Designing a strategy can be challenging because it involves substantial research to uncover a “market edge”. In this activity, the article asserts, mechanical strategies enjoy a clear advantage with respect to time saving and accuracy.
  • Validation involves ascertaining whether the market edge will persist in the future. While discretionary strategies can use “out-of-sample” testing in this stage (applying the trading concept on historical data to see results), mechanical trading can also use “stochastic modeling”, a complex method that uses statistics to generate a huge collection of virtual outcomes.
  • The production phase encompasses all aspects of the actual trading process including; data processing, evaluation, signal detection, capital allocation and buy/sell order management. In this area, mechanical trading offers a clear advantage by virtue of speed, quality and reliability.
  • Termination, a step that is often overlooked, is critical because is determines if a strategy is succeeding in its mission. If not, it can either be redesigned or curtailed. More so than discretionary strategies, mechanical methods can offer clear-cut numerical thresholds as trigger points for reassessment.

While the article doesn’t suggest that computers always trump investment professionals, it underscores the unique aspects of  mechanical trading methods that can lead to successful outcomes for investors.