There are two main streams of thought when it comes to trading systems and strategies. There are those who believe an entirely rule-based system works best. There are others who believe a more flexible approach to trading is required, where guidelines are used, but not fixed rules. Then there are traders, like myself, who fall in the middle, using rules and guidelines to come to come up with strategies that have some flexibility, but also have a discernible edge over time. Here we look at these different trading styles, which approach works best for certain types of traders and the advantage and disadvantages of each. By understanding the differences, hopefully you’ll be better able to find or fine-tune strategies to suit your preferences and personality.
Rule-Based Trading Systems
A rule based system is one which precisely defines a trade set-up, determines exactly how much money will be placed on the trade (position size), as well as what the risk and profit will be.
Basically, once a trade signal occurs, a stop and profit target are placed (which may possibly be moved based on other rules) and there are no further decisions to make. The trade stays on until either the stop or profit target have been hit, or in the case of binary options, the trade expires.
The simplest rule based system is one where a profit target and stop are placed at the outset of the trade, and do not move. There is nothing for the trader to do once the trade is on, except wait for the trade to close via the stop, profit target or expiry.
New traders should typically start with this approach. Everything is defined so there is less emotional involvement (although it can still be emotionally difficult to implement a rule based system). It is also possible to “automate” rule-based strategies by writing a program so that it can essentially run without human involvement. Of course this requires coding skills and a deep understanding of the strategy being employed.
The advantages are that you can precisely define your risk and reward. You know exactly when to take trades, and once the trade is on, there is nothing left to do. By backtesting and using your strategy you’ll gain confidence in seeing that the strategy makes money (if it is a good system) as long as you follow the rules of the system.
The downside is that during a trade you may see market conditions change. During the trade it may become evident that your stop is going to get hit before you target (although it is never a certainty). The rules do not allow you to get out though–you must let your stop get hit.
Since most new traders get quite emotionally while trading, this downside is not typically a major problem since following the rules allows them to be more profitable than if they used a subjective system.
Subjective trading systems are “guideline” based, not rule based. It is up the trader to discern when to take trades, and when to get out.
This type of system is typically by used by experienced traders who have a keen understanding of how the market moves are able to trade with a clear mind, which isn’t too swayed by emotional distractions.
Subjective systems are harder, if not impossible, to backtest. Traders, must simply trade a demo account or real account to get a sense of their success. Subjective systems should still be rigorously tested in this manner. Just because it is a “subjective” system doesn’t mean the trader can do whatever they want. There should still be guidelines, and the trade setups and exit methods used should show profitability over many trades, preferably in a demo account, before real money is put at risk.
Subjective systems have the advantage of being adaptable to changing market conditions. This may allow for slightly more profit potential or a higher win rate than a rule-based system (although not necessarily, as each rule-based and subjective system is different).
The downside is that these systems are hard to backtest, and therefore require the trader simply practice their approach over and over again to get a baseline for how they perform. Emotions may play a larger role in a subjective system, which is why this type of system is typically used only by experienced traders.
Experienced traders typically begin with a rule based system, and then see some potential areas of improvement over months of trading and therefore allow for some flexibility of the system (rule-based to subjective).
Subjective and Rule-Based
As indicated, many experienced traders began as rule-based traders and then later allow for some flexibility as they realize there are areas of their strategy that could be improved by allowing flexibility.
For example, a fixed stop or target may be used at the outset of a trade, but the profit can be increased if the price is running well. Certain trade signals may be skipped if a specific price pattern is present or absent. If conditions change while a trade is underway, the guidelines may allow the trader to take profit or losses early, instead of waiting for the original stop or target to get hit.
In this way there are rules for some aspects of the trade, but other parts of the trade are under the discretion of the trader. Which aspects are ruled based and which are discretionary will be up the individual trader and how they trade.
The advantage is that traders get the best of both worlds, at least theoretically. New traders will typically find they do best with a rule-bases system, simply because they don’t have the market knowledge or discipline to take advantage of discretionary decisions or real-time market changes. But as they progress, implementing some discretionary aspects may yield better performance.
One type of trading system isn’t better than another. It depends on the trader, their experience and their personality/emotional makeup. Some traders will do better with a rule-based system, while others can improve on that performance by incorporating some subjective decisions into their trading. No matter what type of system is used, traders should seek to only risk a small amount of capital on each trade, since even the best traders can experience a string of losses, and if too much is risked a few losses can cripple a trading account.