AlgoStrats Blog

  • By Marco Mayer
  • Posted Mar 29, 2017

Having an Edge in the markets

One of the most important concepts to understand in trading is what it actually means to have an Edge in the markets.

First of all, when we talk about an edge in trading, we mean a statistical edge. A good example of a statistical edge is the casino. If you play Roulette, the casino will have an edge, the “house advantage”. This will make sure that the casino is going to make money in the long run. Everyone who plays there has a disadvantage but it doesn’t mean you cannot win there once in a while. You might have luck sometimes, but that casino edge will always make sure the house makes money, and you lose it in the long run, due to the law of large numbers.

That same law of large numbers is of course also at work in trading which is why it’s so important to understand this concept.

If you’re trading without an edge (with a random entry for example), you’d expect to have about 50% winning and 50% losing trades in the long run. Which is exactly what’s going to happen if you trade often enough to allow the law of large numbers to do its job.

The same way as you can be lucky in the casino, you can also be lucky in trading and you might actually make money in the short-term. You believe you have an edge, you start trading and you actually make money. You’re up nicely after 6 months of trading and you think you finally got it. But then you give it all back again and you’re exactly where you started wondering if your edge has stopped working. But the truth is you might never have had one in the first place, you might just have been lucky!

This happened multiple times during the first years of my trading career. I was trying to apply whatever method I just believed in (some chart/price action pattern for example), and after looking at a few samples on a price chart, I started trading it without having thoroughly backtested the method. This way I either made money once I started trading it, which of course reinforced my belief in the method and then lost it later on. Or I lost money right away and stopped trading the method shortly after. Which might have been a mistake, as I maybe didn’t give the law of large numbers enough time to make money with the edge. In any case, shortly after I started looking for the next holy grail, and unfortunately, there’s no lack of utterly useless trading methods on the internet/books/seminars and gurus who were willing to sell it to me.

In trading, there’s no house advantage you have to overcome (unless you’re trading against your broker), but there are trading costs, which means you actually start out with a disadvantage. The higher your trading costs, the larger this disadvantage will be. So you will lose money in the long run if you trade without an edge as you always will have to pay these trading costs. Truth is, to break even in trading, you already do need an edge to overcome trading costs.

The key point to take away from this is to understand that if you actually do have an edge in the markets, it’s just that. You’re now the casino, you have the advantage. You have the law of large numbers on your side. In the long run, you will win.

Does this mean you’ll be able to predict the outcome of the very next trade you’ll take? Will you know it’s going to be a winner? No, the same way the casino doesn’t know if it will make money in the very next round. Does it guarantee you that you’ll make money within the next 10 trades? No, the same way the casino doesn’t know it will make money on this table tonight. Could it happen that you get 5 losing trades in a row? Absolutely, the same way someone might double his money 5 times in a row playing roulette in your house.

If you manage to really understand and acknowledge this, your trading will become a lot easier. You’ll stop trying to predict what a market will do, knowing that it’s simply impossible to know and that the outcome of a single trade is a random event. This way you’ll pay much less attention to individual trades and be more focused on the long run.

And that’s the only way to succeed in this business. Have an edge, focus on the long run and ignore the noise in between. I hope this article helps you to do just that.

Happy Trading!

Marco



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