A trading edge is the process of identifying market conditions where a trader can execute trades in a way that increases the statistical probability of having a profitable outcome.
A casino has an edge. Overtime they will win more than they lose and it’s in their best interest to roll the dice as many times as possible and let probability run its course. Yes their patrons win here and there, but overall the odds are in their favor and they have a history of analyzable data to project what their performance will be if they continue to keep the game running. Their strategy is working and they are not concerned with each individual win or loss, but rather the entire dataset, and if they are winning more than losing.
As traders we must think like the casino and not like the gambler. Without an edge, trading becomes gambling and we end up taking trades at random with no consistency. If we think an asset is going to go up we buy it. If we change our mind we sell it. Similar to the gambler, we’re taking trades based on emotions, or how we feel it will turn out. There’s no proven strategy or plan to govern our behavior and we end up flailing. In this situation, traders often become obsessed with being right on every trade and hyper-focused on each individual trade's outcome as opposed to tracking their performance over time. There will be wins and losses, but eventually money will be lost as there is no edge to give you an advantage in the market.
Having an edge shifts us into thinking in terms of probability. It becomes less about us being right, and more about following a process that continually produces an acceptable statistical outcome.
What Makes An Edge?
An edge can be defined as any trading strategy you employ that has a high probability of remaining profitable over a series of trades. There are many different strategies, tools and analysis that can be used but an edge can be broken down into these attributes:
- Setup / Strategy - Setup should be well defined and have specific criteria to determine when you take action. This trade setup is rule based and must be consistent in it’s process and every trade taken should look the same.
- Risk Management Strategy - A risk management strategy that determines the dollar amount you are willing to risk per trade. Every trade must be the same size. It must also enforce a risk to reward ratio that ensures your average winning trade is bigger than your average loser.
- Trade Data - A detailed trade log of all setups taken. This produces a large dataset of all your trades that can be analyzed and assessed for what is working and what isn’t. This is also used for determining your Win / Loss Ratio. Assessing our past trades shows us the statistical value of our edge and we can use that to project future performance or make necessary changes.
Finding Your Edge
Developing an edge is crucial to becoming a profitable trader and it’s no surprise that it’s difficult to do. While much of trading can be learned, you could argue that edge must be found. Every trader is different and there are a million ways to approach this game.
If you want to develop an edge, consider adopting these traits:
- Go with what is already working for you, and do less of what isn’t. Is there a specific strategy that really speaks to you? Great, use that. Now focus on refining it. Create a setup that is simple to replicate trade after trade.
- Have a willingness to analyze past behavior and be honest about what works and what doesn’t. This becomes a process that is constantly evolving as you gather more data and your setup evolves.
- Think in terms of probability. One trade on its own is meaningless. You need a large dataset to get an idea of your performance. Look at all of your trading as a big group of trades and look at the statistical outcome. Focus on Win/Loss and Risk/Reward ratios. If either are unsatisfactory, analyze your trade log for clues and changes you can make.
- Work from a trading plan. This is a big picture strategy that accounts for why you are doing this in the first place and what you are willing to risk in the process.
- Get used to being wrong and expect that it will happen frequently. Your job is to implement systems that will help you be wrong less.
What Does Edge Look Like?
Ok hopefully everything above captures the essence of what edge is, but what does it look like in practice? Truth be told you now have to go and implement this in the real world if you ever want to make money from trading.
At TRI we strive for an edge that produces winning trades about 66% of the time with a minimum Risk to Reward Ratio of 2:1. This means that we will be wrong ⅓ of the time but if we can trade with these results consistently we will be quite profitable.
In order to consider your edge valid, you must test it enough to have a sufficient amount of data showing your Win / Loss Ratio. At TRI we suggest a minimum of 100 paper trades to determine whether or not your setup is valid.
Once you have 100 paper trades showing that your statistical performance is satisfactory then you now have an Edge to work with. It may look something like this:
Setup: TRI 3 Reasons To Take a Trade
- Location: At or below RLZ
- Momentum: Confirmed RSI Divergence
- Structure: W in price
- Buy market structure W breakout, risk to the bottom of W and take a 2:1 trade risking $100 Per trade.
- 100 trades taken with 66% Win Ratio. Our losers cost us $100 per trade and our wins paid us $200. All said and done we were profitable.
66 Wins = $13,200
34 losses = $3,400
Net Profit = $9800
An interesting thing to note is in this example we are trading with a high win rate and low risk/reward ratio. But that’s not the only way to be profitable. You may be a trader that loses more frequently but your winners are much bigger and that can work out great as well.
Having an edge brings a structural element to your trading by giving you a framework to trade within. You’ve done the work to figure out what works and now your job is to implement it with as few deviations as possible. It gives you confidence that you have a realistic chance to perform as well as your recent trade history. If something changes it alerts you that it’s time to make adjustments.
At TRI, we teach people how to adopt this trading mindset. If trading with edge is something that interests you then we would love to help get you started on this path. Consider joining our new school program starting in May 2021.