The Path to Successful Trading Part One: The Discretionary Trader

In the broad category of “trading the markets”, there are basically three types of trading: Discretionary, Technical, and System-based.

Every trader usually starts out as a discretionary trader. The amount of money lost generally determines how long it takes the individual to start using technical indicators to make trading decisions. Eventually, as even employing technical indicators fails to move the trader into profitability, the trader moves into the third stage and starts to write systems based on quantifiable data. It is at this stage that the trader ordinarily starts to make money. Finally, the systems and money management strategies are refined and the individual becomes successful as a system trader.

A discretionary trader uses a combination of intuition, advice and non-quantifiable data to determine when to enter and exit the market.

Discretionary traders are not restricted by a concrete set of rules. If you are a discretionary trader, you can make buy and sell decisions using whatever criteria you deem to be important at the moment. For example, you can use both a combination of hot tips and relevant news stories from The Wall Street Journal, and enter or exit the market based on this information. If you begin to lose money, you can immediately exit the market and change your trading method. You don’t have to use the same techniques day in and day out. It’s a very flexible way to trade that you can customize based on what you think the market is going to do at any given moment.

For the discretionary trader, trades are made using gut instinct and intuition. Unless a computer is generating a buy or sell signal and you actually follow the signal, your emotions will affect your trading. Remember fear and greed? In discretionary trading, technical tools such as indicators are sometimes used; however when they are put to use, they are utilized sporadically as opposed to systematically.

Fascinated by the markets, the discretionary trader is ready to put on a trade at a moments notice. The most uncomfortable part of trading for the discretionary traders is when there is no action. So he will jump on any piece of information, anything that will permit him to stab at the market. Above all, he craves action.

Intuition and Hot Tips

The discretionary trader uses several sources for his trading decisions. One is intuition, for example, "I see a lot of people in stores, so I think the economy is good, and earnings will increase, so the stock market should go up, and I should buy Sears." He/She usually spends a lot of time talking to his broker. "What do you think Joe, isn't Target going to turn around?" Another is reading and watching the news, "Retail sales are looking strong and Target is closing stores to lower their overhead."

Hot tips are a common way that a discretionary trader gets ideas. A call from his broker or good friend, or a tip from a discussion at a cocktail party are all places the discretionary trader gets his trading ideas. "Hey George, Reasearch in Motion is coming out with a hot new blackbarry, hers is a stock you can pick up for cheap." If it gets dry in the summer, our discretionary trader may decide to buy corn beans or wheat. However, when he looks out the window and notces its raining, he immediately sells his position. A news story on the nightly news may cause a discretionary trader to short the airline that has just had a crash.

Craves Excitement

What a discretionary trader loves is the excitement. He/She loves being "in the markets," playing with the big guys. He/She craves the risk, the excitement of trading and gambling rush that he gets from calling his broker and putting in the order to buy. He/She loves being able to sell Eli Lilly due to a news story of the health hazards of one of their new drugs. He/She has a real obsession for buying Cotton based on the hot tip from his/her broker that the upcoming crop report was going to be bullish, and he covets the tip from his friend who called to say that he just bought Intel Corp. because the latest quarterly earnings were going to be to the upside.

Discretionary traders retain the flexibility of changing their buy and sell criteria from moment to moment, and change the way they trade from minute to minute and day by day. "Well, that last trade was a disaster, so tomorrow I will buy McDonald's only if it opens up from yesterday's close." They don't have any discipline, nor do they think they need any. They use their intuition and their gut instinct, and feel justified in doing so. They think "Making money is easy, you just have to be smarter and quicker than the next guy."

I personally don't know anybody who has made money by discretionary trading. They may have been lucky and won a few trades, but overall, over time, discretionary traders always lose money.

It is after money has been lost that the discretionary trader in some way stumbles across technical indicators. It may be from the chart book he just looked at where there was a Stochastic Indicator underneath the chart. Or he may have gone to the latest Make a Million Dollars Trading the Stock Market seminar and found out that using the Relative Strength Indicator is the sure way to stock market profits. He thinks, "So this is how they do it!" These indicators look like magic. They add some rationality to an otherwise irrational trading style. He thinks, "This must be how the big money players make big money--they use technical indicators!"

Discovers Technical Indicators

Once the discretionary trader discovers technical indicators, he or she incorporates some rudimentary ones into trading, usually additional justification for making the trade. "Not only did my broker tell me to buy Intel Corp. but Intel also have great relative strength. Intel's moving averages are bullish and the Stochastics are oversold and giving a buy signal as well."

These newfound technical indicators give the discretionary trader a new lease on trading. Now our trader has a whole new world in front of him/her -- the world of technical trading. For a while, this newfound world combines with the intuition and the discretionary trader views himself as a system trader. He says, "I trade a system using moving averages and stochastics with a dash of daily news a tips from my broker. I am not a real objective systems trader." While the trader may view himself as a systems trader this could not be further from the truth. The discretionary trader's style is still undisciplined, based on newly educated guesses, and he is probably still losing money.

For a moment, these technical tools were thought to be the answer, and while they add a little more rationale to his/her trades, the losses continue to pile up. Despite his continuing angst, our discretionary trader is now on the way to becoming a technical trader.