Trading Edge
What is an “edge” in trading?
A trading edge is a belief that a tactic, technique, observation, or knowledge creates a profitable advantage over other market participants.
This can be both a tangible and intangible notion, and I’ll get into that later.
Do trading edges exist or not?
There can be plenty of debate on the reality of the existence of trading edges. Ultimately, everything may be random, but only time can tell that, and for now, testing can show that actions can be taken to give a person a better chance for success or to “beat the market.”
The concepts of trading edges all stem from the underlying idea that the markets are not efficient. This means that frequently prices DO NOT reflect the true value of an asset. This can be for several reasons, such as information asymmetry (insider knowledge), low liquidity, or emotional market participants (fear/greed). These conditions can cause a misrepresentation of value which can be exploited for profit by those who recognize the inaccuracy.
The opposite side of the coin is that markets ARE efficient, that at all points in time, the markets reflect the true value of assets, and that all public and private information are already priced in. No amount of analysis, fundamental or technical, can be exploited to predict or beat the market.
As a technical analyst, the Efficient Market Hypothesis is a hard pill for me to swallow. There is empirical testing to show that people can consistently outperform the market, and there are techniques that will accurately forecast future events. However, there are many, many market participants, and those who underperform outweigh the overperformers and an argument can be made that those who do outperform are doing so solely out of luck and/or due to the law of probabilities; some people will inherently outperform others, and it is fitting of a standard distribution of results.
It’s quite an interesting concept for further exploration if you so choose to expand your knowledge on it. Even though I don’t fall in line with EMH understanding, it helps to realize the opposite of it as well.
Trading Edges
What is a tangible example of a trading edge?
This may include a particular trade setup. For example, I enjoy using price action to confirm and/or trigger an entry for a particular market condition. One such example would be the engulfing candle. Without getting too deep into the technicals, an engulfing candle is when a candle envelops the trading range of the prior candle.
This particular candle pattern shows that the sentiment has shifted from the first candle and reversed on the next candle. There could be many reasons for this change in mood, but it is a tangible representation of one side of the market overpowering the other. One could bet that this trend shift may continue in the reversed direction.
Below is a simple backtested strategy in tradingview using this particular trade setup using Bitcoin on the weekly timeframe. Each candle represents one week. The strategy is buying Bitcoin the week following a bullish engulfing candle and selling at the close of the week, the is only open for seven days. This is not an endorsement of the particular strategy or trading advice. I’ve pointed out two stats in the performance report at the bottom.
The white arrow is highlighting the Percentage Profitable calculation. It is showing 57.14%. This means that out of all the possible trades, it was a successful (profitable) trade 12 out of 21 occurrences. While that’s not ideal, it’s still better odds than 50% or randomly guessing 21 weeks to take a long position.
The yellow arrow is highlighting the Profit Factor calculation. It is showing 2.008. This is calculating the gross profits divided by the gross losses. The ratio shows what was earned from each dollar risked. For each dollar lost, two were won. This is also not ideal, but it’s also still a profitable outcome in the long run.
On a side note, this testing supports the theory that markets are inefficient as there are multiple strategies one can research that consistently outperform the market over time. Many spend inordinate amounts of time and computing power devoted to finding, creating, and backtesting strategies. Quantitative trading IMO is the future of trading the sooner a person can adopt the idea and practices of systematic trading and develop skills in quant trading, the better off you’ll be. Extensive testing shows manual/discretionary trading consistently is beaten by quant trading year over year.
What is an intangible example of a trading edge?
This could be something like insider or advanced knowledge. The ability to “know” something before others to properly position ahead of time is greatly beneficial. There is no shortage of examples of this behavior, both legitimately and illegally. Respectively; think of Micheal Burry of The Big Short fame, whose research into mortgage lending practices lead him to realize and forecast the existence of a housing market bubble, or think of Enron, where multiple executives were convicted on multiple criminal charges when they sold off millions of company stocks before the announcements of the company’s collapse.
This could also be represented in personal knowledge, development, and trading experience. Your brain is your greatest asset. The more time you put into advancing your knowledge and skills that is more of an advantage you have over someone else who isn’t.
When it comes to basic technical analysis, I think four critical trading building blocks to understanding the markets will translate into ANY trading strategy you implement.
Market Structure
Support and Resistance
Trend Identification
Momentum
These will be discussed in detail in later pages.
What else do I need to know about trading edges?
In most cases, they degrade over time, returning to the market efficiency conversation. Let’s say you figure out some particular array of candles that is wildly successful in predicting a move in the market. You trade it over and over and over again, making gobs of money. Others will eventually discover this market inefficiency you’ve identified, either by sheer luck in discovery or by you teaching it to your friends who teach it to others, or by you writing a book or selling an indicator. One way or another, over time, more people will start exploiting this market inefficiency. With everyone competing for the same profit, there is less profit to spread. With more people trading a now well-known setup, this leads to another inefficiency. A counterplay opportunity presents itself to exploit. If everyone is expecting one thing to happen, there is a great benefit to exploiting the opposite side if you can make that happen.
The crowded play and counterplay lead to dwindling profits in the strategy over time; overall, the edge is lost. With the elasticity of the market, it’s possible that as the system/edge falls from grace, it can regain its effectiveness since it has lost favor and fewer and fewer people trade/exploit it, but this is rare. Overall the markets change constantly, and even if your system/edge has no one using it anymore, the market dynamics and conditions that existed for it to work in the first place may be gone entirely.
If you want a good historical example of this, look into Dennis and William Eckhardt and the Turtle Traders.
How to develop your trading edge
Investing in yourself is the optimal way to get an edge if you want to make trading a career. Without that investment, you will always put your success in someone else's hands. No one will care about your account/portfolio more than you will. Use your time and energy to make yourself better/smarter than the other traders. In the following pages, we’ll review many things that helped me develop and maintain an edge. It’s a neverending but beneficial process that hope will help you in your journey to being a consistently profitable trader and investor.
Bonus Reading:
Candlestick Patterns I Approve and Use Regularly
Know Your Identity
Just a reminder, when the site is live, it will be distributed to my paid subscribers. Consider joining up.
Thanks, see you tomorrow with the Trading Range Tuesday post.
@theprivacysmurf
Thanks again for all the insight