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Lie 12

15 Lies About Trading And Investing – Lie 12

Lie 12:  Automated Systems Remove Emotions From Trading

During the dot com bubble burst, many traders withdrew from the markets after realizing that they could not profit from classical technical analysis. The brokerage industry survival depends on the revenue from executed trades and that started decreasing. The technical analysis gurus came to the rescue by telling traders that the reason for their losses was not the flaws in technical analysis but their emotions. Automated trading systems were presented as the solution to this problem.

Although it is true that an emotive trader can interfere with the proper execution of a profitable trading system and automation is the solution for that, the fact is that most systems are not profitable to start with and it is irrelevant whether emotions are removed by automating them. Despite this fact, the new automation narrative helped the brokerage expand by offering more hope to retail traders. However, the problem is that emotions can never be removed completely because they are part of the trader.

By automating a system, the trader is prevented from interfering directly with the trade execution. This is true but there is another type of interference that is related to switching the system on and off. The brokerage industry avoided discussing this effect of emotions although some houses started to offer a full service system execution that would take the trader completely out of the loop.

When a system runs in automated mode, most traders that were involved with its development know whether it makes or loses money either through simulation or by just watching the account equity. Emotions can cause a trader to switch off a system due to fear of losing more money. This is the main reason that system automation does not remove emotions from trading and it is another lie that is repeated constantly.

In the early 1990s I developed a system for someone who had access to capital. The system was based on an idea that individual had but I turned it into a complete system. That individual knew about the problem of emotions and how they can affect a trader because he was close friend with a CTA. He asked me to automate the system as much as possible. Since automation was in its infancy in the early 1990s, I offered a version of the system that executed on a personal computer and informed the trader about new signals after updating all data files. A broker at a large brokerage firm was assigned the task of monitoring the signals of the system and execute them so that the owner would not interfere with its operation. That was in theory how this should work…

A few months after the broker started trading the system I visited the brokerage for unrelated business and I found out that its developer had order its termination due to drawdown accumulation. Actually, I learned that the owner of the system interfered frequently with its execution. Since he was the owner of the trading account, the broker could not refuse the instructions. I was also told that he asked the broker during certain periods not to take short or long position in some contracts.

When I simulated the system I found out that had all orders been taken, the system would have recovered from the drawdown and made profits. The fact that the system was almost automated did not prevent interference due to the emotional state of the system owner. The narrative that automated systems remove emotions is a lie. Nothing removes emotions as long as the trader can monitor account profit and loss and system performance. It is amazing how the availability cascade cognitive bias has worked with this particular lie: a solution to a complex problem was proposed and gained popularity because some adopted it. This solution is still offered in trading books and on brokerage ads even though most of the traders that have used automation are already ruined. Another useful narrative to replace the “automation removes emotions” narrative has not been invented yet. I suspect that soon the brokerage industry will try to make everyone a high frequency trader and this will be the basis for the new narrative. However, high frequency trading is still profitable as long as there is a barrier to entry due to the high cost. When the retail crowd enters this game it will be too late to profit, as always.

About dealing with the problem of emotions and interference with automated trading I know only of one practical solution: traders must use high probability strategies. The high the win rate results in lower drawdown levels and the negative effects on the emotional state of the trader are in this way minimized.

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