What Is A Trading Edge?
An edge means that over a large sample of trades, a trader will come out with a profit. Without an edge, nobody can make money from the market in the long run.
The above definition is just scratching the surface, there is much more to understand about this concept.
What will be discussed?
- Understanding edge.
- Components of an edge.
- Why is a strategy essential to trading success?
- What should be included in a strategy?
- Step by step process to find and implement a trading edge.
- Common mistakes.
When a trader has an edge, they are trading with a positive expectancy i.e. the probability of making money are in their favour.
A common comparison to an edge in the financial markets is the edge that casinos have over their clients. The casinos know the mathematics behind each of the games they offer and because of this, they know profit will be made over the long run. There is one difference present in this comparison
Casinos know that when a client beats a game they will have to pay a large sum of money, however, they are paid small amounts when they win i.e. casinos lose big and win small. Traders aim to do the opposite, lose small and win big (obtaining the best risk to reward)
Casinos make up for this because the probabilities of a large loss are low, so it does not occur often. In contrast, those small wins happen every time people walk through the door.
Edges are all about calculating and exploiting probabilities, more on that in the next section.
Components of an edge
Having, or not having, a positive expectancy is dependent on a few simple components – Win %, loss%, average win, and average loss.
How often the result of your trade is a win, if you win 6/10 trades then your win percentage sits at 60%.
How often the result of your trade is a loss. Simply minus your win % from 100 to get this, using the above example that would be 40%.
The average value of your winning trades e.g. $100.
The average value of your losing trades e.g. $75.
Ok so we have all the factors that determine an edge, but what next? Take the information and calculate if we have a positive expectancy.
Edge = (Chance of a win x Average Win) – (Chance of a loss x Average Loss)
And that, ladies and gentlemen, is how you can simply determine positive expectancy. If this equation spits out a + then you would make money. If it returns a – then your account is in for some pain.
Why is a strategy essential to trading success?
You cannot pull an edge out of a magic hat. A trading strategy is required to objectively determine if you are trading with a positive expectancy.
A trading strategy is a set of rules that determines when a trade must be placed. If these rules are not met then a trader should not trade.
Without the consistent application of the same principles, all trading results are random and it is impossible to know if the probabilities are in your favour. This is why all traders need an approach.
Next, let us look at what should form part of a trading strategy.
What should be included in a strategy?
- Analysis – Strategies are based on some form of analysis. This could be sentimental, technical, or fundamental analysis.
- Entry rules – Conditions that must be met for a position to be opened e.g. the test of a Fibonacci retracement level with a confirmation candlestick.
- Exit rules – At which levels or under what circumstances should a trade be closed? The setting of stop loses and take profits is included in this.
- Risk – What % of your account are you willing to risk per trade and overall at any given time?
- Position sizing – What should your position size be based on your risk parameters?
- Pairs – Which Forex pairs are you going to trade?
- Timeframe – Determine the timeframe that you will execute trades on and will you implement multiple timeframe analysis?
Building a strategy, with rules for the above points, is the first step to gaining an edge in the market. Bringing us to the next section.
Step by step process to find and implement a trading edge
Finding an edge is a grueling journey but here are some steps to make it easier.
1. Develop your trading plan
As mentioned above, a strategy is required for traders to stay on track and remain objective in the Forex market.
2. Determine expectancy
Your next job is to backtest your strategy and/ or trade it live (with low risk). Take note of the results and use the equation from earlier to calculate if you are working with a positive expectancy.
Move onto the next step if the results are near break-even or profitable. If the base idea is bleeding money then chances are it will not be profitable, rather try another approach.
3. Analyze the data and improve
Up until this point, you have been trading based on an idea of what could be a profitable approach. Now it is time to look at ways to improve the system and gain an edge.
4. Ensure you have an edge
Use our equation again and find out if your system is profitable – If it is then continue to the next step. If not, repeat step 3 continuously or try a new system.
5. Execute objectively
Congratulations, gaining an edge is an achievement of note, however, the job is not done. Now your focus must shift to remaining disciplined and executing your edge without fail.
Great traders strive to improve their approach, make sure you do the same (check out the Trading Journal – Explanation And Tips article for more on that).
6. Manage your risk
A great system without capital is worth nothing so make sure you adhere to your risk limits and stick around for the long term gains.
Not testing large enough sample sizes
Many newbie traders will have a sound idea but will abandon the approach after making a few trades. You need to test large samples (around 100 trades) to get an accurate idea of the expectancy.
Mixing too much analysis
Another beginner mistake, it is easy to think that adding more analysis will further confirm the probabilities in your favour, but this is not necessarily true.
Yes, confirmation is important, however, over-analysing makes it impossible to trade and may distract you from the core of the methodology.
Neglecting different market environments
A certain strategy can work well in one market environment but fall apart in another. Make sure that you test in all conditions to confirm that your approach is robust and has an edge.
I hope you have come out this article with a better understanding of what a trading edge is, how you can calculate it, and the process of finding a positive expectancy in the markets.
Until next time.