Mechanical System vs Trader's Judgement

Yet another thread which I originally posted in Bizfun.

Traders have long identified that emotions/psychology is the major factor in trading.

In fact, many advocate following a mechanical system to avert this emotion factor. The whole idea of this mechanical system is the Law of Averages.

First find a system that works most of the time. The key here is most of the time. Why? Simply because we know that there is no holy grail. There is no system that work all of the time. That is also why we have stop loss in a system to protect ourselves against the inevitable.

So if you have a system that works most of the time, theoritically you should make money in the long run. E.g. A Trading System with 80% accuracy. Out of 10 trades made, 8 are correct. 2 resulted a stop loss trigger. Assuming that the profit or loss are equal (which in practice this is not practical, stop losses are normally lesser.

However, our calculation is such that it would be more prudent to calculate a larger loss and a smaller profit as to avoid rosy forecast of profits/hyping our own trading system over nothing) then 6 out of 10 trades makes the net profit. Not bad huh?

However, as we all suspect there is a problem. The problem of mechanical trading system is that it is mechanical. Yeap, the advantages of a certain system is often the weakness of the system. A mechanical system cannot distinguish the underlying market condition. It cannot say differentiate between the bull market and the bear market.

The trading buy may make sense in a bull market but may not make sense at all in a bear market. Allow me to illustrate.E.g. In a bull market, breakouts are normally (key here is normally) genuine. In a bear market, breakouts are often false with no follow throughs.

So what happens to the system? It cannot distinguish the underlying market condition - hence a higher number of stop losses occur with the same system in a different underlying market condition!!!

So therefore, some advocate an adjustment to the trading strategy.
In a bull market, use Trading System A.
In a bear market, use Trading SYstem B.
Some even advocate, for Stocks - follow the System A and B approach.
For Futures/Derivatives, use System C and D respectively.

Sounds good heh?
We started off with a mechnical system and then moved on to improve the problem of the system. Still no emotions involved. Problem is, hahaha there s always a problem when you ask a perfectionist. (Of course the problem with the perfectionist is that he is searching for non existent perfection).

Okay, problem is that the market dynamicism and volatility.
Problem is also the Law of Averages.

The market is ALIVE.
The market is ever changing everyday.
While today the bulls may be in force, tomorrow, the bears may be decided the victor.
Are we to switch the system in the span of one day?

Another question - The Law of Averages. It states that in the long run, you should make money with this certain system.
Could you withstand a 100 losses with that system?
What happens if the 100 losses are your first 100 trades with the system?
The Law of Averages rings true only, and only, if your sample size is large enough. If your total trades of a certain system is 1,000,000 trades, sure enough, it would tell you whether the system works or not.

Imagine this, I flip a coin.
Guess if its heads or tails?
Theoritically we know that there is a 50% chance its head and there is 50% chance its tail. Now would it be possible if I flip 10 times in a row and its head? But would it be possible to flip head in 1,000,000 times? Chances are there will be about 500K heads and 500K tails or close....

Hence the problem with Law of Averages.
So, what do I advocate? Judgement.
The subjectivity of our own judgement.
Best supported with other mechanical techniques either TA or FA.

But to the end, we must make a subjective judgement if the system will work with this particular stock or not.

Alas, I began to see that Trading indeed is an art.
Good Luck and Happy Trading!