The vast majority of individuals who pursue a career actively trading financial products eventually give up trading altogether. Academics have examined the failure rates of traders within the financial industry for decades, with one famous study concluding that a chimpanzee throwing darts could pick stocks better than a novice equities trader.1)Retrieved 27 January 2016 http://www.businessinsider.com/terry-odean-on-stock-picking-2012-12

Even though the odds facing an active trader seem daunting (success rates being commonly estimated around 10%), longevity within the marketplace is a prize enjoyed by some. The financial markets provide the possibility of achieving financial reward, and there are many different philosophies that are championed in the pursuit of that objective. Discretionary trading is one such methodology.

What Is Discretionary Trading?

Discretionary trading is the practice of executing trades based solely on the judgment of the individual trader. Fundamental analysis, technical analysis and trader intuition can be used to make trading decisions within the framework of a discretionary trading approach.

Advantages

Discretionary trading may offer a few key advantages to the trader within the marketplace, with the biggest being the speed of trade selection and eventual execution. A discretionary trader operates as a sole entity. The ultimate authority in deciding whether or not to place a given trade lies in the trader’s own hands. Without the need to receive authorisation from a client or superior, the trader has the ability to capitalise instantly on a perceived setup.

The second major advantage that a discretionary trading approach provides to the trader is the ability to make adjustments to his or her methodology on the fly. The markets have a myriad of possibilities and are dynamic in nature. Systematic, mechanical and directed traders may lack the ability to tailor their approach to the most current market conditions. As a result, they can sustain large losses as the system traded becomes obsolete. It’s more simply said than done, but the discretionary trader has the opportunity to adjust the trading approach as warranted by market conditions.

A discretionary trading approach often includes provisions on how to handle unexpected market disruptions. During the “flash crash” of 2010, the Dow Jones Industrial Average fell more than 1,000 points in minutes, and it had a tremendous impact on trading accounts worldwide. A study of the flash crash identified one mutual fund’s immediate sale of S&P futures worth US$4.1 billion as the potential root cause of the crash.2)Retrieved 3 February 2016 http://www.thestreet.com/story/13137356/1/flash-crash-of-2010-is-history-but-stock-markets-are-still-vulnerable.html

Algorithms and automated trading systems went haywire in the face of the huge volumes flooding into the markets, and many trading firms sustained massive losses. A discretionary trading approach could have prompted the trader to close positions and limit losses immediately instead of assuming the increased risk posed by an extremely volatile market.

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Pitfalls

The single largest drawback of employing a purely discretionary trading approach is the emotional attachment a trader can develop with his or her individual trading decisions. Each trade setup is scrutinised and either taken or passed on according to the individual trader’s judgment.

Due to the fact that trader judgment is the sole basis for making a discretionary trading decision, the trader’s confidence in his or her decision making is crucial to success. A period of market variance and account devaluation can shake this confidence and hinder performance. Conversely, extended periods of success can bolster the trader’s confidence and lead to altered decision making. In both scenarios, the consistent application of the trading approach is likely to suffer.

Another key drawback of implementing a discretionary trading approach is the element of human error. In today’s electronic marketplace, the physical act of placing and managing a trade is a challenge. The speed by which markets are able to move is measured by minutes and seconds, rather than in the hours and days of yesteryear. Institutional investors equipped with cutting-edge technology can execute thousands of trades per second; each round turn measured in milliseconds.3)Retrieved 25 January 2016 http://www.nytimes.com/2011/01/02/business/02speed.html?_r=0

From a discretionary standpoint, the physical act of order entry and subsequently the trade’s management are prone to increased slippage and outright human error. Automated order entry has a major advantage over human order entry when entering and exiting the marketplace. Over time, the physical errors attributed to the trader regarding entry to and exit from the market can dramatically affect performance.

Summary

The vital aspect of discretionary trading lies within the individual trader’s temperament. Decisions are made solely by the trader, therefore the gains and losses realised are a direct reflection of the trader’s abilities and overall performance. Utilising a discretionary trading approach is not for every trader, so be sure to do your research and/or speak with an independent financial manager before utilising this approach.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

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