What Is Edge?
Every trader has a slightly different interpretation and definition of “edge”. If you asked 1,000 traders what their edge was, they would all have different answers even if they trade similar strategies and markets.
However, one characteristic of an edge in which all traders will universally agree is that it makes you money over time. Not on a trade-by-trade basis, but over hundreds and even thousands of trades and multiple months and years.
It is highly personal and includes psychological components, as bad trading psychology can easily sabotage a trader’s edge and cause them to lose money when they should have made money.
It does not necessarily have to mean that they win more trades than they lose, although for some traders it does mean that — but more importantly it means that over time their winners always make up for their losses (and then some).
Losing is a part of the game, after all. In trading, there is no way to avoid losses.
If that is the case, how does a trader make money?
The answer is a matter of simple mathematics. You cannot control whether you will have losses or how much you will win on each trade, but you can absolutely control your risk exposure for those losses and the quality of the setups you choose to take.
In other words, you can choose how much you lose on each trade, and you can choose when to trade. This is where a trader’s power lies: risk management. The combination of high-probability and the elimination of big losers allows for the accumulation of big winners over time.
If you have traded long enough, and you are wise enough to collect detailed statistics about your trading results, then over time you can develop a concise picture of the technical workings of your edge and how to best exploit it or defend it against catastrophic drawdowns by simply adjusting your position sizing (or strategy if necessary).
For those who don’t know what a drawdown is, it means the maximum amount of money you lost along the way in order to get to whatever gain you ended up with. So if I say I had a 10% annual drawdown, that means that during the year, I lost 10% of my total equity at one point.
If you have a strategy with a 45% win ratio and a 1:2 risk to reward ratio, you probably can’t risk 2% of your total equity per trade. In fact, you probably shouldn’t risk more than 1% per trade given that it will not be particularly unusual to run into 6 or 7 or even 10 losing trades in a row.
If you are risking say 5% per trade with such a strategy, then the winning times will be exhilarating and the losing times will be devastating and potentially lethal. Sustainable, consistently profitable trading does not look like that.
However, if you had a 58% win ratio with a 1:2 average risk to reward, then maybe you could stomach 2% risk on a trade. Perhaps even 3% or more of your total equity on your best setups. Most sensible professional traders would probably never go that high on a single setup, nor recommend retail traders to, but for the more aggressive traders with genuine edge, it is not unusual and in fact can be quite profitable to trade this way.
That is not to say a 58% win ratio won’t also run into uncomfortably long losing streaks, but they ought to in theory occur less often with a higher win percentage. So it all depends on your personal tolerance for drawdown. That is why there is no ‘one size fits all’ strategy that trumps all other strategies. You will trade my strategy differently to how I do; either better or worse, and vice versa — even with the same rules.
Some traders are comfortable with a 30% drawdown, others can’t handle 10%. Length is also a factor traders should take into consideration. The higher your win ratio, generally speaking, the shallower and shorter your drawdowns will be (in theory). The opposite is generally true for a lower win ratio. But a strategy that loses often may make more money than a strategy that rarely loses (depending on the average Risk:Reward).
This is why risk to reward is equally as important as win ratio, and the two cannot be analyzed separately in a meaningful way. A higher reward often means a lower win ratio. When developing a strategy, it is important to balance the two. If you are shooting for 1:10 risk to reward trades, then expect to experience significant strings of losses.
Large or small risk to reward does not matter in itself. As long as the strategy makes money over time, then what matters most is that it performs in a way that is compatible with your psychological make-up.
If you are the type of person who is impatient and hates being wrong, then trading a 1:10 RR strategy is going to be hell for you even if it makes money, and you aren’t likely to trade it to its full potential.
You are better shooting for more conservative targets and winning more often, but being heftier with your position size because you can afford to be. That is how you make your edge work for you if you don’t have the patience or discipline to wait for big winners, or if you find the multiple swing-and-miss approach too difficult to endure.
If you are a busy person who doesn’t have time to stalk perfect trades or doesn’t care if you lose ten trades in a row occasionally so long as the 11th pays for them all, then go for it. Give trend-following a try or wider swing trading, or develop some kind of position strategy that allows you to hold trades for longer periods of time. The world is your oyster.
Just remember to manage your risk appropriately.
Developing An Edge
The conclusion from all this is that an edge is not necessarily a reflection of your ability as a trader to be correct in your analysis. If that were the case, all of us would be out of the business pretty quickly. The market is far too complex a beast for any one man, especially a retail trader, no matter how intellectually or game-theoretically gifted, to outsmart or outwit every time.
Rather than trying to do this impossible task, a technical trader plays the casino instead. They find a set of variables and patterns that, if acted upon in a consistent manner, produce profit over time.
Technical traders study a certain market to learn its behavioral characteristics, then they determine which market conditions are best suited for certain trading opportunities, then they develop rules to specify when they should or should not enter or exit a position based on that potential opportunity. Then they test that theory with either historical data or live data, or both.
With this data, the trader can then determine the basic characteristics of the strategy. Its estimated win ratio, how often losing streaks occur, how bad the worst drawdown period was, how long it lasted, what the average risk to reward is and so on.
Using this data they can then develop a portfolio (limiting their trading to only the best performing pairs/stocks/etc) and money management plan that suits the strategy, as well as develop a rough idea of what to expect going forward. Obviously past results are not indicative of future performance and all that, but it is the best we have and without it you are trading blind.
Once a trader has determined that the strategy indeed makes money over a large enough sample size of trades to give them confidence that their good results were not simply the effect of a lucky hot streak, they start out small and trade the strategy as consistently as possible.
As the trader develops confidence in the strategy, learns it intimately and trusts in their own ability to execute it effectively, they either increase their position size (if it suits their money management plan to do so) or their risk capital (account balance).
This is the natural progression of a consistently profitable technical trader, as far as I can tell. It is a simple process really, but it does take time and the work is often grueling and unrewarding and monotonous. By the time you have confidence in a strategy from the appropriate efforts at testing, you will be so sick of it that you might not even be enthusiastic about trading it at first.
But once the results start to resemble your testing, that is when the fun begins and you start to gain momentum. That is when the rubber meets the road and you start to feel like you have earned the money you are making, because it is not the result of random chance or gut feelings but the result of months of hard work spent developing a meticulous trading plan and then having the courage and discipline to stick to it.
That is a trader’s job. That’s what we are paid to do. Sit down, be humble and let the market tell you what you should do next.
Trade your edge. Not your shirt.
Originally published at zenandtheartoftrading.com on October 29, 2018.
