Subjective or Rule-Based Trading System

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Subjective or Rule-Based Trading System?

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.

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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.

Objective vs Subjective Trading

Objective vs Subjective Trading

Objective vs subjective trading: Most traders follow either an essentially objective or subjective trading style. Objective traders follow a set of rules to guide their trading decisions. They prefer to have buy and sell decisions essentially pre-planned. In contrast, subjective traders disavow using a strict set of rules, adapt to changing market conditions, and base their trading decisions more on their judgment regarding a specific trading Algorithms (Algos) Algorithms (Algos) are a set of instructions that are introduced to perform a task.Algorithms are introduced to automate trading to generate profits at a frequency impossible to a human trader opportunity.

Subjective traders are usually more vulnerable to falling prey to various behavioral finance biases or to being guided by emotion rather than reason in their trading decisions.

While there are disagreements about the merits of objective vs subjective trading, most traders are in agreement about the wisdom of approaching the market with an established trading plan Resistance Line A Resistance Line, sometimes also known as a Speed Line, helps identify stock trends and levels of support and resistance. Resistance lines are technical indication tools used by equity analysts and investors to determine the price trend of a specific stock. . Using a trading strategy or system that you’ve tested and practiced makes it easier to make good trading decisions in real time, under sometimes volatile or rapidly changing market conditions.

Objective Trading

Objective trading is also referred to as rule-based trading, and it is the simplest way to trade. The trader follows a clearly defined set of rules for trade entry, exit, time frame, order types, and markets. It is designed more like a “set it and forget it” automated trading system. The trader merely waits until his criteria are met for initiating a trade. He takes a position in the market, and then enters “take profit” and “stop-loss” orders to manage his eventual exit from the trade. After that, it is pretty much a matter of just letting the trade play out, either hitting his profit target or being taken out of the trade by his stop-loss order being triggered. His trading strategy may have rules for adjusting profit targets or stop orders in accord with market action. However, he will usually be much less active in that regard than a subjective trader.

New Traders

Due to the relative simplicity of objective trading, it is ideal for new traders who lack the skill and experience required for complex market analysis and interpreting trading signals. A set of rules to guide both trade entries and exits can lower the stress level and psychological pressure that novice traders may naturally feel. An objective, rules-based trading strategy also helps new traders to avoid one of the most common beginning trading mistakes – trading driven by emotion. Strict rules to follow will also provide important risk protection.

Subjective Trading

Subjective trading is more appropriate for experienced traders who are familiar and comfortable with the markets they trade. Experienced traders also have more of a “feel” for price action. For example, they are better equipped than beginning traders to be able to accurately assess whether a market move is merely a temporary corrective action or an actual trend reversal. Having seen plenty of price action patterns unfold, they can more easily detect and correctly interpret various patterns of price movement in the market.

Subjective trading is not just trading based on feeling. Successful subjective traders don’t just take trades at random. Their trading decisions are still guided by a trading strategy. And subjective traders employ very objective market analysis in making trading decisions.

The key difference between subjective and objective traders is simply that subjective traders do not consider making market entries and exits just based on a set of rules to be the most effective trading strategy. Instead, they believe in the value of evaluating each specific trading opportunity in light of recent price action, current market and economic conditions, and yes, their “gut feel” for the market, honed from years of trading experience.

Whereas objective traders follow more precise rules, subjective traders are more inclined to operate using just general guidelines. For example, objective traders may follow a rule that tells them to always place their stop-loss order 20 points from their trade entry price. Subjective traders exercise more flexibility in regard to where they place stop-loss orders, but do employ general guidelines that help determine an appropriate amount of risk for each trade.

Adapting to Changing Market Conditions

Securities prices can fluctuate substantially even over the near term and market conditions are always subject to unexpected change. These basic facts of trading give an edge to subjective traders who are more inclined and prepared to continually adjust their market position. Objective traders who are more constrained by trading rules are less likely to be able to successfully navigate their way through rapidly shifting market conditions, pressures, and trends.

Objective vs Subjective Trading – Some Examples of the Difference

An objective trader is likely to be entering trades based on a rule such as, “Buy when price moves above the 50-period moving average”. A subjective trader may consider buying at that same point. However, rather than making an “automatic” entry based on a rule, they will first take into consideration things such as the perceived momentum of the market’s price action. For example, does the movement of price above the 50-period moving average appear to be a high-momentum breakout move? – Or does it look more like the last gasp of a market that is severely overbought and possibly due for a downside correction?

The objective trader is looking more at a generic type of trading opportunity. The subjective trader is focused more on identifying the specific nature of “this” particular trading opportunity. An objective trader will, therefore, make more generic trading decisions. A subjective trader will aim to more precisely identify the risk and reward parameters that apply to a specific trade.

When they place a stop-loss order, the subjective trader will again be disinclined to just use a hard and fast rule for stop placement. Instead, they will select a stop-loss price level based on both acceptable risk and on factors such as the recent and/or anticipated level of market volatility.

Once in a trade, as noted above, objective traders are likely to use rules to select a profit target. The subjective trader’s selection of a profit target is likely to be more nuanced and more guided by the specific market conditions prevailing at the time. It will also be more readily subject to rapid re-evaluation if market conditions appear to be shifting.

Objective vs Subjective Trading – A Final Word

Neither objective nor subjective trading is “right” and the other “wrong”. It is simply a matter of which trading style a given trader is more comfortable with or has a preference for. Objective trading is probably the best trading approach for novice traders just because subjective trading is more dependent on trading skill and experience that can only be acquired over time.

Thank you for reading CFI’s guide to subjective vs objective trading. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ FMVA® Certification Join 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Trading Mechanisms Trading Mechanisms Trading mechanisms refer to the different methods by which assets are traded. The two main types of trading mechanisms are quote driven and order driven trading mechanisms
  • Daily Trading Limit Daily Trading Limit The daily trading limit refers to the maximum amount by which the price of a stock or other exchange-traded security can rise or fall during a trading session. The limits are decided by the exchange in an attempt to avoid extreme volatility or manipulation in the markets.
  • How to Read Stock Charts How to Read Stock Charts If you’re going to actively trade stocks as a stock market investor, then you need to know how to read stock charts. Even traders who primarily use fundamental analysis to select stocks to invest in still often use technical analysis of stock price movement to determine specific buy and sell, stock charting
  • Technical Analysis – A Beginner’s Guide Technical Analysis – A Beginner’s Guide Technical analysis is a form of investment valuation that analyses past prices to predict future price action. Technical analysts believe that the collective actions of all the participants in the market accurately reflect all relevant information, and therefore, continually assign a fair market value to securities.

Rules based trading strategy. 6 Steps To A Rule-Based Forex Trading System

Rules based trading strategy learn more, check out our Trading Systems Tutorial. Ensure You Have Enough Money A Cash is the fuel needed to start trading and without enough cash, your trading will be hampered by a lack of liquidity. 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.

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Subjective or Rule-Based Trading System?

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6 Steps To A Rule-Based Forex Trading System

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Rule Based Systems vs. Discretionary Systems Part 1

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