- What is rules based trading?
- Pros and cons of rules based trading
- What is discretionary trading?
- Pros and cons of discretionary trading
- Which is better?
- What type of trader are you?
What is rules based trading?
Say that you are going to go grocery shopping and you make a checklist of all the things you need to buy. Just when you get to the store, you look for those things only and put them in your basket.
Rules based trading is just like that. Traders have a trading checklist and they look for that to happen in the market and they trade accordingly.
A trade that trades with a rules based strategy might do something like this:
Condition 1 - Price above 200 EMA.
Condition 2 - 100 EMA above 200 EMA.
Condition 3 - Price making higher highs and higher lows.
Entry - Previous swing high.
Stop loss - Previous swing low.
I’m not saying that this is a proper strategy but I’m just giving you an example of how a rules based trader would think.
They’d have proper pre-defined rules for their strategy and as each condition is satisfied, they act upon and trade only when all conditions are met.
Pros and cons of rules based trading
As you saw in the example above, traders trade with set rules and they stick to those rules at all times.
This can have both advantages and disadvantages and I’ll tell you how.
The advantage is that these traders will never have their emotions or gut feelings interfere with their trading activities.
They’ll never just look at the price and just say “I think the price will go up, so I’ll buy.”
No, they’ll never do that. They will act only on the basis of the rules and will do only what they should do according to the rules.
The disadvantage could be that this would give them no room for flexibility and adapting to the market if they haven’t planned for it in advance.
There will be times when the strategy that a trader is trading, may require some tweaks. But if the trader is strictly a rules based trader, then they might not make any tweaks at all and it may cost them.
When deciding whether rules based trading is for you or not, you need to weigh these advantages and disadvantages and you need to know what would work better for you.
What is discretionary trading?
I’ll take the grocery shopping example again here. Say that you don’t make any list before going to the grocery store and you enter and start picking up things as you see.
This is not what discretionary traders do exactly but yes, they would trade what they see and they would have their subjectivity play some role.
Discretionary traders may look at the price, have a look at the left of the chart to see how it has moved, and they might develop a bias and trade based on that.
They may not necessarily have any set of rules that they’d stick to and their trades are based on what they see and what they think may happen.
Pros and cons of discretionary trading
The pros and cons of discretionary trading are just the opposite of the pros and cons of rules based trading.
The advantage that discretionary traders would have is that they can be flexible with their trading activities and they can adapt and change their approach to the market based on what they see.
Since they have no set or specific rules to always stick with, they can make tweaks and do what wouldn’t have done before.
This could also be a disadvantage for such traders as it would make them more subjective and allow their emotions to influence their trades.
And we know what emotions and gut feelings can do to us traders, it’s a double edged sword.
Which is better?
If you want an answer to this question then I can’t give you the answer. Only you know what’s better for you.
With this blog post, I just wanted to lay down the nuances of both trading styles, give you their pros and cons, and then you have to decide what works for you.
You should mainly understand what type of a person are you? Do you like having rules and acting only based on those rules, or do you like having some flexibility?
Once you have the answer to this, it’ll become easy for you to know what trading style is better for you.
But let me tell you one thing, I believe more in rules based trading and I myself trade only with rules that I have made for myself.
I had even read this quote somewhere that all discretionary traders are rules based traders only haven’t just written down their rules or haven’t defined them properly.
But still, do whatever is suitable for you and what works for you best.
Maybe try and test strategies with both styles and see how you react to them and if you can keep up with what it requires from the trader trading them.
What type of trader are you?
So tell me, what type of trader are you? Do you have set rules that you follow all the time? Or do you allow your trading to have some subjectivity and flexibility by trading with discretion?
Whatever trading style you use, you should know how to manage risk always, or else you’ll go bust with any style you trade.
Don’t forget to share this blog post with others and let them also know about these two trading styles and they can also decide which one to stick with.
Feel free to ask me any questions in the comments section below and I’ll get back to it at the earliest.