Discretionary Trading vs. Rules-Based Trading

—Jim Dalton

Here at DLC Profiles, we teach discretionary trading, which is to say we're not "systematic" traders, offering tactical, rules-based trading information. This limits our potential client base to those select few traders who want to understand how markets function, and who appreciate how important their individual role is to both their financial success and their psychic satisfaction (it's not surprising to discover that the best traders often have the highest psychic needs - driven to achieve mastery over any endeavor they encounter through sustained, concerted effort). These traders accept that learning to trade is a skill that only develops over time, and that success is the result of accumulated experience.

Consider this simple metaphor to illuminate the rigors of the learning process…to acquire a new language, you must first memor-ize words and verb tenses and parts of speech - which is itself a challenging prospect. Then it takes years of study to become conversational. But then it takes a quantum leap of intuition and deep knowledge to think in a new language. One of the indicators of fluency, in fact, is when you begin to actually dream in a second tongue.

Most potential clients that contact us are looking for rules-based trading systems or approaches. Using rules to make money is, of course, incredibly appealing; however, such cut-and-dried rules are seldom accompanied by the most important rule - a rule to connect, manage, and harmonize all the other rules.

In short, you must be able to view any given rule contextually, or else the rule has no value.

Rules that are not understood and applied contextually may even serve to accomplish the opposite of their original intent; it is the lack of a "contextual rule" that casts doubt on most trading systems.

The appeal of a systematic approach is obvious: reduced emotional stress, sure profits, lack of personal responsibility, and im-mediate results - without years of building expertise. And if the rules don’t make money for you, then the blame can be placed on the rules, and not you. At the same time, you can accept credit for all profits since, after all, you selected the system.

Something there Is that Loves a Rule

I recently ran across a book by Scott Thorpe entitled How to Think Like Einstein: Simple Ways to Break the Rules and Discover Your Hidden Genius, which eloquently summarized my thoughts regarding the ways in which rules can hinder personal develop-ment. I heartily recommend that anyone interested in developing discretionary skills add this book to their collection.

Einstein once said, “Few people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment. Most people are even incapable of forming such opinions.” Anecdotal evidence continues to suggest that the number of short-term traders that succeed is extremely limited, which leads me to reiterate: if you do things the same way everyone else does, odds are you'll finish in the middle of the distribution curve - which, anecdotal evidence would suggest, means you'll suffer financially. Most traders employ a rules-based approach.

Dictionary.com defines a rule as “a basic generalization that is accepted as true and that can be used as a basis for reasoning….” Nothing is said about the rule being tested for validity, or how the rule was derived. We are asked to accept it and move on. Thorpe says that, “We all have rules-ingrained patterns of thinking that we mistake for truth,” and that when rule “ruts” form, “all conflicting ideas are ignored.” He continues: “Rules stunt innovative thinking because they seem so right. They hide the numerous superior situations that exist, but are outside our rules.”

Thorpe makes the point that our experiences, mistaken assumptions, half-truths, misplaced generalities, and habits keep us from finding reliable solutions. I would elaborate here: these issues become even larger when new traders are guided in the wrong direc-tion at the beginning of their learning experience.

There is a bewildering range of variables that affect any commodity, futures contract, or stock. And there are nearly limitless com-binations and permutations of these variables. If a purely rules-based system were to be truly effective, it would have to offer a rule for each possible arrangement - an impossibility. Discretionary trading is about building a solid foundation, upon which one can make reasoned judgments based upon constantly changing conditions and a highly developed fluid intelligence. (In another CL/ CES Cognitive Market Commentary, we discuss “fluid intelligence,” which is wholly dependent upon mental flexibility.)

The concept of a rules-based approach to trading brings to mind two of my favorite quotes, from H.L. Mencken and Thomas Edison.

“There is always an easy solution to every human problem - neat, plausible, and wrong.”

—Mencken

“Hell, there are no rules here—we’re trying to accomplish something.”

—Edison

The Power of Discretionary Trading

Rules-based systems do not account for contextual market conditions, and are not adaptive to constantly evolving market con-ditions. On the other hand, discretionary traders can quickly alter the way they view and interpret shifting market data. The dis-cretionary trader needs to understand how markets perform under an extraordinarily wide set of circumstances. Rules-based, or mechanical systems, can be implemented immediately, whereas discretionary traders must spend considerable time learning and acquiring the necessary knowledge to trade. As I've said many times over the years, the learning period required to become an expert trader is similar to that required to become a doctor, lawyer, or top athlete.

Rules-based approaches, providing they are followed religiously, are not faced with the psychological short-comings, biases, or lack of discipline that often effect discretionary traders. Discretionary traders are constantly performing their own market analyses, and are required to spend considerably more time and effort both before and during market hours. This time requirement also limits the number of markets or securities discretionary traders can successfully follow.

Fundamental analysis is the purest and most easily understood form of discretionary trading; employing quantitative techniques and computer analysis does, in fact, include "rules," because most of the results presuppose certain assumptions. But these rules must be evaluated differently depending upon the phase of the market—the context. For example, the same set of results for rising interest-rate markets are viewed quite differently in a falling interest-rate environment.

Technical analysis can fall into either category, depending upon how the analysis is determined. For example, a mechanical moving average system is rules based, and not dependent upon market con-text. Visual interpretation of chart patterns, however, can be discretionary if the trader is interpreting them based upon current market conditions.

DLC Guidance for Discretionary Traders

We suggest that you begin with understanding how your brain processes information. The left brain analyzes information in a se-quential manner, and is only capable of performing one function at a time. This is the hemisphere responsible for speech—it keeps your words in order. The right hemisphere synthesizes information and can perform several functions simultaneously, making it adept at recognizing patterns. While it is true that decision-making without analysis is unlikely to prove meaningful, it must also be said that decision-making based solely on details—that fails to synthesize the information in question—also bears little fruit.

In my first book, Mind over Markets: Power Trading with Market Generated Information, I take you through five development steps: Novice, Advanced Beginner, Competent, Proficient, and finally Expert. These steps describe the general progression that must occur in order to perfect any skill. Once you understand this process, you'll be more prepared to set your personal growth goals, and you can be more realistic about your development.

Mind over Markets serves as a primer, with myriad short-term tactics for understanding basic Market Profile nomenclature and theory. Even if you eventually plan to trade from a longer timeframe, we suggest that you begin by studying the nuances of day trading; everyone is a day trader on the day they enter or exit a trade. But please keep in mind: Mind Over Markets is only a primer; situational learning—which will ultimately enable you to forget the context-free "rules" and trade in an intuitive, whole-brained way—requires a source pool of observations and experience that can take many years to nurture and develop. The trading principles DLC Profiles teaches are the same for all timeframes, but starting with the day timeframe will enable you to accumulate the required observations in a more efficient, logical fashion.

Markets in Profile: Profiting from the Auction Process expands upon the theory behind the Market Pro-file; expands upon the market’s intermediate and longer-term auctions; introduces a greater dispersion of trader timeframes; and discusses in detail the importance of inventory distribution among all timeframes. As one reviewer wrote, "If Mind over Markets was the Old Testament, Markets in Profile is the New Testament."

Great Reads for Discretionary Traders

As part of our ongoing educational support, DLC Profiles suggests reading materials—books that are seldom on markets, but rather explore subjects like behavioral finance and how the brain processes information. The reason for this is as simple as it is potentially controversial: we believe that self-understanding is more important, over the long term, than market understanding. Or, as Einstein put it…

"Imagination is more important than knowledge."

—Einstein

We are confident that we can teach you market understanding, but when it comes to your path to self understanding, we can offer only directional hints and  resource guides that will help illuminate your knowledge of the unique way you react to learning, information, and ultimately the perils and promise of trading. For example, read Mozart’s Brain and the Fighter Pilot: Unleashing Your Brain’s Potential by Richard Restak, M.D. The book is as fun to read as the title would suggest, and the New York Times described it: “A personal trainer for your brain.”

Sample chapters:

•Develop your powers of metacognition: Thinking about your thinking

•Turn your feelings and emotions to your advantage

•Develop a tolerance for uncertainty

•Think of your brain as the creator of incredibly rich and fascinating montages

•Train your powers of logic

DLC Profiles Cognitive Trading Process Seminar is our most basic seminar, designed to help you improve your ability to capitalize on change. The seminar incorporates the essentials covered in Mind over Markets and Markets in Profile into your personal trading.

DLC Profiles Cognitive Trading Process Intensive is limited to eight participants, and is comprised of three phases: preparatory, residency, and six months of advanced support. The goals are to:

•Deepen your understanding and interpretation of market-generated information.

•Further your understanding of not only your own timeframe, but the timeframes of others and how they interact, co-exist,

and merge.

•Enhance your decision-making process based upon your increased understanding of your brain’s hemispheres, and the

role they play in making a trading decision.

•Establish a foundation for the design of your path to gaining cumulative experience.

We believe that continuity - uninterrupted education and practice - is the most positive, powerful path toward becoming a competent, discretionary trader. We can help you unleash the power in accumulated experience.