The Pitfalls and Risks of Mechanical Trading

If you are on the trading mailing lists, you may have seen an increasing number of offers for trading robots in recent months, and being impressed by the statistics to back up their claims of vast profit. It seems it is possible to setup a system using, for instance, MetaStock software, and just look in from time to time to see how much it has earned for you.
You may be wondering about the need to take a trading course or to get a trading education when it is so easy, with no technical knowledge, to gain a reasonable income from the markets. Or perhaps you have wondered why the vendors would be seeking to sell their system, typically at $97, when all they need to do is use it to make all the money they want.
Of course, it is never as easy as it is portrayed. These mechanical systems have been shown to perform based on historic data, and that gives no guarantee that they will continue to do so. In fact, the more they are optimized to produce fantastic figures for past markets and to reject possible losing trades, the more complex they become and more specialized for what has been in the past, rather than for the future.
The more successful mechanical systems are usually based on trend following. Depending on the market being traded, you may find it is truly trending only a part of the time, and the rest of the time it is ranging in nature. Range bound systems are also available, though it is unlikely that the vendor of the system will let you know sufficient details so you can identify the best market to use his system on.
Back testing to prove the system may also misrepresent the performance which could have been attained. For example, it is not always possible to get execution at the indicated price because of illiquidity, poor timing, or perhaps a gap opening. Nonetheless, back testing may be what convinces you to try the particular mechanical system.
Finally, if you examine the settable parameters of these mechanical trading systems you will find that many of them use a very wide stop loss margin. Part of their success is that they do not jump out of a trade that starts in the wrong direction, but ride it down and back up again. While the natural cycle of the market makes this course of action feasible a lot of the time, it means that if you do hit the stop loss you must be prepared for a major setback.
You may notice that this is the opposite of the best trading advice, which tells you to cut your losses and ride your gains. Don’t think that you can avoid this by setting the stop loss to a smaller margin, as then you may be stopped out of more trades. The system designer will have optimized the values for best back testing performance.
The best way to make consistent profits out of trading the markets is to have sufficient flexibility to identify the correct trading strategy in any particular situation, and this comes out of having a sound trading education and hands-on experience, rather than leaving your critical financial decisions to a black box.