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TE04 - What is a Mechanical Trading System?

"A mechanical trading system is something that you will come across during your journey as a forex trader. But what exactly is a mechanical trading system and why is it so widely talked about in the forex circles? A mechanical trading system, as the name suggests is a trading system that is based on technical indicators. The buy and sell signals are generated based on a simple set of rules. When these rules or criterion are met, the trader takes a long or a short position. In the forex markets, traders either make use of a mechanical trading system or one that is based on discretionary based trading system. Remember that there is no right or wrong way to trade. Both these approaches comes with its own pros and cons. It is up to the trader to understand what approach they are better at when it comes to trading. In this article, we look at what a mechanical trading system is all about."

One of the main aspects about a mechanical trading system is that it is not discretionary. A discretionary based trading system is something that is subjective in nature. This brings a bit of complexity along with it.

For example, chart patterns and price action based trading systems are discretionary in nature. What one trader will deduce from their analysis can differ compared to another trader. Thus, the trading signals are not consistent and it entirely depends on the trader who is analyzing based on these methods.

As you can see, there are some significant shortcomings with a discretionary based trading system. Therefore, most of the times, traders leave the discretionary based trading systems for manual trading methods only.

A mechanical trading system on the other hand gives clear and concise trading signals. Regardless of who is using a mechanical trading system, the signals cannot be missed.

It is this ease of use that mechanical trading systems are widely used in automated trading strategies.

Why are mechanical trading systems used in automated trading?

We mentioned earlier about how a mechanical trading system works. The signals are easy to identify and one just needs to buy or sell based on the signals generated by the system. A mechanical trading system can make use of an existing set of technical indicators.

In some cases, traders can also make use of customized trading indicators as well. Still, no matter what type of technical indicators are used, a mechanical trading system is easy to implement.

Because automated trading systems are simply pieces of code, traders can easily code or program such a mechanical trading system.

It allows traders to use a set and forget method of trading. In other words, based on the way the algorithm or the technical indicator based trading system is coded, one can easily set it up and forget it.

Of course, it is not just about the trading signals but also other aspects that are coded. Examples include position sizing, risk management and so on. These trading systems are easy to use and typically work across various technical trading platforms or charting platforms.

Example of a simple mechanical trading system

Now that we know what a mechanical trading system is all about, let’s take an example of a very simple mechanical trading system.

A moving average indicator based trading strategy can be the basis of this very simple example. We already know that when a short term moving average crosses above the long term moving average, a buy signal is generated.

Likewise, when the short term moving average cuts below the long term moving average, a sell signal is generated. Now you can easily automate this trading system. Your program or piece of code will include a set of rules that automatically buys when the value of the short term moving average is above the long term moving average.

Similarly, when the short term moving average value is below the long term moving average value, a sell signal is generated.

As you can see, this simple trading system is easy to understand. There is no subjectivity involved in such a method. This is nothing but a simple mechanical trading system in play.

You can build up many different types of mechanical trading systems using this method. In fact the MT4 trading platform has something called the Expert Advisors. Among the different EA’s, the moving average crossover is a default automated trading system that you can use to experiment.

Drawbacks of a mechanical trading system

While a mechanical trading system is easy to implement in terms of building an automated trading system, it still has its own drawbacks. For example, a mechanical trading system doesn’t account for the changing market conditions.

Some trading systems are more suited for trending markets (such as the example mechanical trading system mentioned earlier). If such a system was to be used in a flat or ranging markets, you will come across a lot of losing trades.

This is where a discretionary based trading system is more ideal. It allows you to easily change your approach depending on how the markets are behaving. The markets can switch from trending to ranging and vice versa within a short period of time. Thus, a discretionary based trading system gives you more flexibility in this aspect.

But having said the above, a mechanical trading system is quite easy to use and can bring in good profits, if you know when to put that strategy to test and when to stay away from the markets.

Read 933 times Last modified on Friday, 26 July 2019 16:27