Why you should have a trading edge?

You must have a definite source of trading edge. This is something that gives your trades positive expected value. Very loosely speaking, for something to be a source of edge it must be correct and not widely known. This second part is often forgotten.

What is your Trading Edge?

If you know only what others know, this is valueless. It will already be priced into the market. This is why, even if I was so inclined, it would be impossible for me to give you a recipe for profitable trades. The publishing of the recipe would render the trades generated from it almost immediately useless.

Looking for positive expected value is not the same as making only trades that we expect to win. This flawed thinking leads to the nonsense, “You only have to win more often than you lose.” This is simply wrong. The winning percentage of a trader is not enough to know if he has been, let alone will be, successful.

A similar error is perpetrated by those who refuse to buy options, on the basis that most expire out-of-the-money. This is a mistake made by even the most experienced traders. Jim Rogers, commodity trader extraordinaire and cofounder of the Quantum fund with George Soros, is quoted as follows in Market Wizards by Jack Schwager:

I don’t buy options. Buying options is another fast way to the poorhouse. Someone did a study for the SEC and discovered that 90 percent of all options expire as losses. Well, I figured out that if 90 percent of all long option positions lose money, that meant that 90 percent of all short option positions make money.∗ I do not know what SEC study Rogers refers to. The 90 percent figure he gives may be true, but it is irrelevant. Profitability is the important thing to consider, not winning percentage.

The 10 percent of winning trades might have won so much that they made more money than the 90 percent of losing trades lost. Similarly, when considering a potential trade, expected value is the crucial metric, not the percentage of winning trades. Equally incorrect is the adage, “Let your profits run and cut your losses short.” This is based on the flawed idea that if your winners are bigger than your losers, all will be well. But this is not true if your losses sufficiently outnumber your winners.

The important metric is expected value. Expected value is defined as the probability-weighted value of the payoffs, summed over all possible outcomes.

For example, in the case of a trade that can have only two outcomes,

EV = Pr (win) × payoff (win) + Pr (loss) × payoff (loss) (9.1)

So if someone has offered us a bet on the toss of a fair coin, where he will pay us $1.10 if we win and we pay only $1.00 if we lose, our expected value is 0.5 × 1.1 − 0.5 × 1 = 0.05. So we expect to win 5 cents, on average, when we play this game. As this is greater than zero this is a good trade for us. Note that in no single playing of the game will we win 5 cents. We will either win $1.10 or lose $1. Expected value is an average.

Trading Edge Essense

This is the essence of good trading: finding, making, and managing trades with positive expectancy. Everything else: news, business conditions, macroeconomics, technical analysis, psychology, and so on, must be subservient to this concept.

A good trade is identical to one with positive expected value. Further, a good trader should be prepared to put on any trade if the price is good enough. For example, even if you think volatility will increase, you should be prepared to sell options if you get enough trading edge.

Backtesting and Trading Edge

If your trades have positive expectancy you will succeed. If not, you will not. You must have some idea why a particular trade has positive expected value.

Back-testing an idea will show you that something has worked in the past, but there are an infinite number of combinations of trade ideas, parameters, and products. Obviously some of these will have produced successful trades in the past.

We need to know why they will do so in the future. This gives us confidence, but also tells us when to stop a particular trade. If you have no knowledge of why something worked in the first place, it is very tough to know that it has stopped working.

Evaluating its diminishing effectiveness just from watching the results can be expensive
and is also often difficult, as all trades will go through bad stretches.