Systematic vs Discretionary Trading – The Ultimate Comparison

Algorithmic trading has gained more and more popularity over the past few years. Due to high costs and complexity, algorithmic trading used to only be available for institutional investors and traders, but with ever-improving technology, the internet, and online quantitative trading platforms, the entry barrier for algorithmic trading has never been lower.

In this article, we will examine the differences between systematic and discretionary trading as well as the best way to get started with either.


Systematic vs Discretionary Trading – Video Breakdown

Check out the following video in which I compare discretionary and systematic trading.


What is Systematic and Discretionary Trading

Before we get into the comparison of these two trading methodologies, let me first quickly clarify what I mean by systematic and discretionary trading. Discretionary trading is a trading form where you manually open and close your trades. Even though you might still have a trading plan, you usually rely on your discretion on when the best time is to open or close a position.

Systematic or rules-based trading is a trading form where you have a clear system with exact rules that tells you when to buy or sell a given security. System traders usually use algorithms to automatically execute their trades. In this article, we will focus on algorithmic system trading.

Let me give you a simple example to show the differences in a systematic vs discretionary trading approach. A discretionary and systematic trader both want to buy a given stock in case of an uptrend. A systematic trader would have a very specific set of rules such as “the 200 day SMA is below the 50 day SMA” for identifying an uptrend. The discretionary trader, on the other hand, would rely on their discretion, market awareness, a variable set of indicators, intuition, and their own judgment to decide whether there currently is an uptrend or not.

Sadly, algorithmic trading is often misunderstood in one of two ways. The first misconception about algorithmic trading is that it is too good to be true. If you can just set and forget your automated trading strategies, why isn’t everyone doing it?

Here it is important to understand that automated does not equal easy. Researching, developing, testing, and optimizing algorithmic trading strategies takes a lot of time and effort. By no means can you expect to generate any noteworthy returns with a strategy that was developed in a few minutes.

The next misunderstanding about systematic vs discretionary trading is that there is no way that an algorithm could compete against a human trader. Due to rapid technology development, this has gotten better over the past years. But there still exist many people with this algorithm aversion. Even though algorithms might not think like humans, they can still be programmed to solve incredibly complex task much faster than any human ever could. So given the right code, a trading bot can certainly outperform a human trader. This is supported by the fact that a very large percentage of the world’s largest hedge funds and banks primarily rely on an algorithm-driven trading approach.


Systematic vs Discretionary Trading

First of all, I want to say that neither systematic trading nor discretionary trading is inherently better than the other. Each methodology brings with it, its own challenges, and benefits which we will discuss next. In essence, comparing systematic vs discretionary trading comes down to comparing man vs machine. Systematic strategies take advantage of the insane speed at which computers can analyze data and make decisions based on this data. Discretionary strategies, on the other hand, benefit from human intuition and all-round intelligence.

With that being said, let’s start by breaking down the advantages of systematic trading

Advantages of Systematic Trading

First and foremost, an algorithmic approach to trading is very different from a discretionary one. You can’t just open a broker account and immediately start trading. You first have to code your algorithm, test, analyze, and optimize it before you actually start risking any significant amount of money. These steps require a sufficient understanding of a programming language, how to handle data, and market structure.

This means that there are many more hurdles between an idea and an actual trade for an algorithmic trader. Even though this can be seen as a disadvantage, I see it more as an advantage. One of the main reasons why so many discretionary traders lose money is that they have no idea what they are doing. They might have watched a few “trading tutorials” on YouTube and then decided to open a broker account. This is a recipe for disaster.

So summed up, algorithmic trading has a higher entry barrier which puts a few more hurdles between you and you making stupid trades. Note that this does not mean that you can’t create bad trading algorithms. But generally speaking, an algorithmic trader has to put much more active thought into every aspect of their trading strategy since they actually have to code it out. A discretionary trader, on the other hand, can just mindlessly start buying and selling random securities if they want to.

I know this entry barrier might seem offputting and overwhelming for some people. But with the internet and the availability of so many great free resources, it has never been easier to learn how to code and get into algorithmic trading. You don’t even have to buy your own data or build your own trading engine due to the rise of so many great algorithmic trading platforms. All you have to do nowadays is to learn their API, and you are good to go. For a list of some great platforms, check out my article on the best algorithmic trading platforms.

Besides that, another big advantage of systematic trading strategies is that they can be backtested. This means that you can actually analyze their historical performance before risking a dime. This is something you simply can’t do with a discretionary trading strategy. For discretionary strategies, it is very hard to evaluate their performance without actually having traded them for a long enough period of time.

Furthermore, systematic strategies are much more consistent and mechanical since they aren’t influenced by human emotions. In my opinion, the biggest problem with discretionary trading strategies is that emotions and subjectivity get into the way. If you are confronted with the exact same situation more than once, you might not always make the same decision. This cannot be said for an algorithmic approach. This lack of consistency is another reason why it can be hard to reliably evaluate a discretionary trading strategy.

In general, well-developed systematic trading strategies tend to have more rigorous risk management models. Especially when confronted with losses, humans tend to be very emotional which can make it hard to cut a loss. Second-guessing a trading decision can cost you valuable time and money. A trading algorithm would immediately close a position as soon as the correct criteria are met.

In addition to that, since systematic strategies usually are automated, you won’t have to spend hours in front of the screen monitoring and scanning the markets for potential trading opportunities. Once a trading algorithm is implemented and tested, you won’t have to spend nearly as much time monitoring it as a discretionary trader would spend monitoring the markets.

Last but not least, from my own experience the discretionary trading community is filled with fake trading gurus and marketers that spread so much false or just bad information while trying to sell you their products. Actually finding sound and valuable trading-related education can be a real hassle especially when you are just starting out and can’t yet evaluate what information is good. I have personally not found nearly as many shady marketers and as much bad information in the world of algorithmic trading. I suspect this has to do with the higher entry barrier which limits the potential target audience for these sketchy marketers.

Next up, let’s discuss the advantages of a discretionary approach.

Advantages of Discretionary Trading Strategies

Discretionary Trading

A trading bot will do exactly what you tell it to do – not more, not less. While an algorithm runs, it neither feels nor thinks the way a human would. Even though a lack of emotions usually is a good thing when making decisions, a lack of a deeper understanding of the underlying problem can also be a bad thing. A human could take previously unknown information into account which a bot couldn’t. The bot only considers what it has been programmed to consider. It can’t use its intuition or intellect to take new information into account. A bot only considers the data it was given. This can sometimes lead to obviously bad trades that no human trader would ever make.

Humans excel at all-round intelligence, whereas bots usually excel at one specialized thing such as analyzing and evaluating vast amounts of data within milliseconds or even less. Depending on the situation either one of these skills can be better. It is possible to create dynamic trading algorithms, but generally speaking, it is easier for a discretionary trader to adapt to new situations than for a trading algorithm to adapt its strategy. Some experienced traders sometimes even make some of their trading decisions on a subconscious level based on the available information and their experience.

Last but not least, discretionary trading is much easier to get into since all you need is a funded brokerage account and you are ready to go. But like I said earlier, this ease of access can be a double-edged sword since many beginners immediately start risking their hard-earned money without actually having a clear trading strategy or deep enough understanding of the markets to make any informed trades.


Conclusion

Systematic and discretionary trading have their differences and their similarities, but in the end, I wouldn’t claim that one is inherently better than the other.

In fact, research from the hedge fund AQR Capital shows that “there is little evidence that one approach is better than the other” when comparing discretionary and systematic fund manager’s performance. This finding is supported by other research in the area.

Depending on the trader and strategy, both can underperform and significantly outperform their respective benchmarks. This is supported by the myriad examples of highly successful discretionary and systematic traders. A good discretionary trader can easily outperform a poorly developed trading algorithm, but so can a good systematic trader.

If you are asking yourself which approach you want to adopt for your own trading, you should ask yourself which skillset fits you best. If you are good at handling your emotions, staying calm in stressful situations, and manually identifying price trends, discretionary trading might be the best approach for you. If, on the other hand, you struggle with your emotions while trading, and prefer a more scientific, data-driven, rules-based approach, systematic trading might be the best choice for you.

That said, it is also possible to combine the two approaches. You could, for instance, use a trading algorithm to create buy or sell recommendations and then decide at your own discretion whether to follow them and how to do so.

Even if you prefer discretionary trading, I’d still recommend systematizing your trading to some extent. You don’t need to code your own trading algorithms and automate everything. But you should still have a general set of rules to follow as well as a clear trading plan, and consistent approach. Especially when you are just starting out, this is very important. You should always seek to improve your trading, and in my opinion, the best way to do so is by identifying your own strengths and weaknesses. By doing this, you can focus on your strengths and work on your weaknesses.

The best way to improve your trading is by consistently tracking your trades and analyzing your trading data. If you want to learn how to best possibly do this, make sure to check out my guide on the best trading journal software.

If you are just starting out make sure to first focus on educating yourself as much as possible before risking any significant amount of money. You can’t expect to become a profitable trader of any kind without putting in the time and effort.

If you want to get started with algorithmic trading, make sure to check out my algorithmic trading video playlist.

4 Replies to “Systematic vs Discretionary Trading – The Ultimate Comparison”

  1. Hi,

    From my online research on the topic systematic vs discretionary trading let talk about the two of them the traders will need to decide between a systematic approach— one based on specific rules that determine markets and entry and exit points —or a discretionary approach, which may include technical data and rules but where the trader maintains the final decision on a trade. There are numerous variations of both systematic and discretionary trading strategies. Many strategies incorporate both to varying degrees and could be defined as a systematic strategy with discretionary overlays or a discretionary strategy with systematic overlays. The one overriding difference between the two styles is that systematic trading strategies generate a definitive signal, whereas a discretionary strategy allows the trader to make the final call on price and time.

    Thank you for sharing

    Aluko.

  2. I think both systematic and discretionary trading, are equally good. And I think that depending on your needs you may decide to chose one over the other.

    Is there any way that one could shift from one to the other anytime needed? Because I am still a beginner at trade, I would like to start with systematic trading. Because I think it will be safer as I am still learning about trading. And maybe when I know more on the subject and be able to enter my own data according to my knowledge.

    Thanks

    1. Thanks for your comment. The knowledge gained from one of the two is certainly transferable to the other. No matter what you choose, you will have to develop a good understanding of the markets. Besides that, systematic trading requires some technical knowledge (coding, data science…) which you might have to learn before being able to switch from a discretionary to an automated approach. 

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