What is a Mechanical Trading System?

Mechanical trading refers to any system of trading which relies upon objective entry and exit criteria. This is not to be confused with automated trading which is carried out by software programs. A mechanical system is designed, tested, and executed by you, the trader. You could contrast mechanical trading with discretionary trading, where your subjective view of the situation plays a larger role in your decisions. Most traders are neither entirely mechanical nor discretionary with their methods, but apply a combination of both for success.

What are the components of mechanical trading? You’ll want to write down (yes, physically write down) a plan which includes which currencies you’ll trade, what time frames you’ll view and trade, how many trades you will take at a time, what your entry and exit criteria will be, and how you’ll set stop losses and take profits. The mechanical system may or may not include certain indicators. Usually these kinds of systems are technical in nature; fundamentals need to be analysed, which is a discretionary tactic.

In a perfect world, you could follow your mechanical system to the letter, and profit at a certain expected margin. You’ll discover that expectation by backtesting on historical data and demo testing in real time on live data. Mechanical trading can instill discipline and build confidence. It is good for emotional traders who need some structure to keep their trepidation or excitement in check.

We don’t live in a perfect world though, and at some point you’ll probably have to make discretionary choices for example when you want to trade in volatile markets. You can even make rules for your choices though! That’s how you can trade mechanically and discretionarily at the same time. For example, you can create a rule that says, “My target is 1:1, but if price hovers around support/resistance for more than X amount of time, I will decide to exit at support/resistance.” This is discretionary, but still constrained by mechanical factors, which is why it is a hybrid exit rule.

Experiment in your trading testing and you’ll find out what works best for you! And remember—everything changes, and you will have to adapt your system eventually to those changes. So even if you trade mechanically, don’t get too rigid!