Hello traders! In today’s post, we’re diving into a crucial concept for anyone involved in trading or speculation: the trading edge. This is the first part of an ongoing series where I’ll share essential insights that I believe every trader needs to know to stand a chance at trading profitably. So, let’s get started by breaking down what a trading edge is and how you can identify if one exists in the system or opportunity you’re looking at.
What is a Trading Edge?
A trading edge can be defined as having a complete distribution of all possible outcomes that, when summed together after computing the expected value of each individual outcome, provides a value greater than, less than, or even equal to zero. In simpler terms, it’s a mathematical advantage that indicates whether your trading strategy will generate profit or loss over time.
This might sound complex, but it’s actually a straightforward concept once you understand the basic math behind it. You can easily calculate this with your own data, which is what makes this idea so accessible and useful.
Calculating Expected Value
The expected value of each possible outcome is calculated by multiplying the probability of that outcome by the payoff you’ll receive from that outcome. The payoff can be either positive or negative. Your edge is the sum of all expected values from all possible outcomes. The result tells you how much money you can expect to make or lose on average if you were to take a given opportunity repeatedly.
What I love about this definition is that it’s mathematically sound and applicable beyond just trading. You can apply this concept to any situation that offers different payoffs based on different outcomes.
Example 1: The Edge of a Day Job
To illustrate the concept of a trading edge, let’s look at a simple example: a regular day job. Imagine you have a job where you get paid $100 for each day you go to work. If you don’t go to work, you make $0.
Let’s assume the probability of you making it to work on any given day is 99% (accounting for possible reasons you might miss work, such as being asked not to come in or an unexpected event). The probability of not making it to work is therefore 1%.
Using these figures, we calculate the expected value:
- Expected value of working: $100 (payoff) x 0.99 (probability) = $99
- Expected value of not working: $0 (payoff) x 0.01 (probability) = $0
Adding these together, your expectancy (or edge) is $99. So, on any given day, you can expect to earn an average of $99. Even though you make $100 on the days you work, your expected daily income accounts for the days you might not work.
Example 2: Trading Currency Pairs
Now, let’s apply this to trading, specifically looking at a Forex pair using a buy-and-hold strategy. Imagine a distribution of daily price returns in pips (the unit of change in Forex currency pairs):
- The blue line in our example represents the distribution of daily returns in pips.
- The red line indicates the payoff structure, which is linear for a straightforward buy-and-hold strategy.
If you take a position in any underlying asset (stocks, Forex, futures), you’re dealing with a linear payoff structure. Leverage may change the slope of the payoff line but doesn’t affect the overall edge or expectancy of the system. This is crucial to understand because many trading resources emphasize risk management, money management, and discipline as critical factors, but these elements alone do not create an edge. They merely amplify or reduce the returns within an existing edge.
If the distribution of returns is symmetric and centered around zero (i.e., no skew), the expected value of the system is zero. In other words, over many trades, you would neither make nor lose money, assuming no trading costs. Most Forex pairs exhibit this kind of distribution over the long term, lacking any significant skew, which means that consistently profitable trading on a purely directional basis is unlikely without an edge.
Importance of Skew in Returns
For a trading strategy like buy-and-hold to be profitable, there needs to be a skew in the distribution of returns. If the skew is positive, the expected value moves above zero, indicating a profitable edge for long positions. Conversely, a negative skew indicates an edge for short positions.
For example, the S&P 500 index historically shows a slight positive skew, meaning it has a higher probability of closing up rather than down. This inherent skew provides an edge for long positions, which is why buy-and-hold strategies generally work in equity markets. However, such skew is rare in currency markets, where prolonged trends in one direction are often followed by trends in the opposite direction, balancing out over time.
The Role of Volatility and Kurtosis
Other statistical characteristics like volatility and kurtosis (the “tailedness” of the distribution) influence the range and frequency of returns. High volatility may lead to larger price swings, but without skew, the expected value remains zero. Therefore, these factors impact the risk and potential reward but do not fundamentally change the edge unless skew is present.
Key Takeaway: Understanding Your Edge
The most important takeaway here is to grasp that a trading edge is purely a mathematical concept based on the expected value of outcomes. No amount of risk management, psychology, or discipline can create an edge if the system itself doesn’t have one. If you’re evaluating trading systems or educational programs, always ask about their edge. If they can’t demonstrate a statistical edge using these principles, then the system is unlikely to be profitable over the long term.
Conclusion
In conclusion, a trading edge is the only thing that can make you consistently profitable in trading. This edge comes from the expected value of all possible outcomes in your trading system’s distribution. While risk management, psychology, and discipline are important, they only modify the impact of an existing edge—they don’t create one. Always ensure the system you are using has a proven edge before committing to it.
Thank you for reading! If you found this post useful, please like, share, and subscribe to our blog for more insights on trading and speculation. If you have any thoughts or questions, feel free to leave them in the comments below. Stay tuned for more posts where we’ll dive deeper into trading strategies and the math behind them. Happy trading!