Discretionary Trading

Discretionary trading refers to the decision approach used by traders based on their instincts, human expertise, and intuitions. It is mostly used in the financial markets by traders to make decisions relying on their gut feeling instead of following strict rules. They mold them as per the current market situation. 

The use of discretionary trading system brings a lot more flexibility in volatile situations. It helps in adapting to changing market conditions and captures opportunities that are often missed. Also, it includes different strategies and tools at the same time. However, in some cases, the trader's decision can turn wrong as well. 

Discretionary trading is a stock market term used by traders when they make decisions based on gut feelings and instincts. It serves as a vital tool when action should be quick and instant. Also, it incorporates different strategies and analyses before making decisions. Thus, traders, based on their intuitions, can take control over the investment related decisions and trades placed in the market. However, the discretionary trading rules do not follow one strategy as a whole. 

In general, discretionary trading strategies are also employed by brokers and individual investors. As per FINRA (Financial Industry Regulatory Authority) rules, brokers can make trades in the customer's account without consulting them first. They can also decide on the trade duration and investment in stocks and bonds with no customer input. However, FINRA only allows discretionary trading authority on written consent by customers. Also, the broking firm must provide consent for such trading in the account. It is only then possible to have discretion over the trades placed. Or else, unauthorized trades are strictly forbidden by FINRA. 

At times, brokers may attempt such trading and cause illegal activities to occur in the customer's account. As a result of which, the latter may face consequences in further trading sessions. For instance, in March 2016, FINRA suspended two Kentucky brokers when they broke rules and overruled the discretionary trading authority in around 80 customer accounts without their consent. To hide the incident, they created back-dated notes that were akin to customer conversations before placing the trades. Likewise, a Florida-based representative placed 14 discretionary trades in three customer accounts. However, court trials led to fines imposed on both cases. 

This trading involves certain discretionary strategies and techniques. Let us understand them in brief:

• Fundamental and technical analysis: Traders tend to develop strategies with a combination of fundamental and technical analysis. Here, they try to analyze the stock's fundamentals and compare them with market indicators as well. And later on, based on their gut feelings, the investment decision is made. 
• Risk management: Often, investors do not rely on already established risk management strategies. Instead, they create their own. It helps them with uncertain price fluctuations pertaining to the financial markets. For example, traders may deploy position sizing, stop-loss orders, signals, and diversification to avoid such risk. 
• Market sentiments: In simple terms, market sentiments refer to the investor or broker's views on a particular stock or instrument. They may have positive sentiments on a stock and tend to invest in it. Likewise, a negative sentiment may advise them to react to the opposite. 
• Instincts and psychology: In the same manner, instincts and intuitions of the investors also form an integral part of discretionary trading strategies. Traders end up trusting their gut feeling and later capitalize on their decisions, thus driving the security prices in the market. 

Let us look at some hypothetical and real-time examples of discretionary trading system to understand the concept better:

Example #1

Suppose John is a finance advisor working as an equity trader for the past four years. In the initial years, he traded with the market sentiments. In the later stages, John started employing technical analysis also, along with company fundamentals. But he was unable to make a profitable investment out of it. So, he consulted a broker and handed the trading to them. Kevin, a registered broker, was able to make trades for John as per discretionary trading rules. However, unauthorized trades were happening in his account. 

On investigation, it was found that Kevin was able to place trades but did not get consent from John. As a result, the former was able to place illegal trades worth $1 million from customer's accounts, including John's. Therefore, John decided to take the discretion of trade into his own hands and perform further trading. 

Example #2

According to a recent news update as of February 2024, the Man Group Plc, an investment management firm, decided to merge its discretionary trading units after the departure of Teun Johnston, CEO (chief executive officer) of GLG. Likewise, brands like GLG, Varagon, and Man Global Private Markets will also discontinue their operations. In return, a combined discretionary business will be a new marketplace for traders to develop and implement strategies. 

Following are the points that explain the pros and cons of discretionary trading in financial markets. Let us look at them: