Incremental Alpha Attributable to Discretion, 02/21/07
Here are two ideas, one for calculating the incremental alpha attributable to discretion and another for using incremental alpha as the foundation for a training methodology for discretionary traders.
Incremental Alpha Attributable to Discretion
Convert trading rules to Key Ideas and then into mechanical systems.
Subtract the sum of the mechanical results from the sum of the discretionary results.
The net is the incremental alpha added by discretion.
My current estimate of the incremental alpha for professional discretionary traders in short time frames is .5 to 3 times the mechanical edge. So a 2 tick mechanical edge becomes a 3 to 6 tick edge in the hands of a professional trader.
Incremental Alpha as a Training Methodology for Discretionary Traders
Convert discretionary trading rules to Key Ideas and then into mechanical systems.
Use the mechanical systems as suggested entries/exits for incoming traders.
Subtract the sum of the mechanical results from the sum of the discretionary results, the net is the incremental alpha added by discretion.
Increase the trader trainee's bankroll as incremental alpha and consistency increase.
A Metric: On average, it takes 2-3 days to go from discretionary rules to Key Idea to mechanical system.
Notes: "Incremental alpha attributable to discretion" is a great turn of phrase by Brett Steenbarger.