I ended my previous column with the concept of an “Edge.” In this column, let me pick up the concept of an edge again.
To understand the concept of an ‘edge’ in trading, I’d like to first talk about the concept of the ‘Holy Grail’ as explained by the mythologist, Joseph Campbell.
“The Grail becomes that which is attained and realised by people who have lived their own lives. The Grail represents the fulfilment of the highest spiritual potentialities of the human consciousness.”
-Joseph Campbell, Joseph Campbell and the Power of Myth with Bill Moyers
Campbell studied the hero’s journey in our narratives and contemporary myths, outlining the single pattern of the hero’s journey across cultural narratives. An important part of the Hero’s journey as outlined by Campbell, taking off from the Arthurian myth, was the quest for the “Holy Grail.” To Campbell though, the quest for the Holy Grail was in actuality, the search that eventually brings the hero to a realisation that what he sought was deep within himself.
And this quest for the ‘Holy Grail’ is what I like to compare with the ‘Edge’ in trading which every aspiring trader needs to develop.
“In theory, a trading edge is a certain approach, observation, or special technique that gives a trader a cash-generating advantage over others in the market.” (TheBalanceMoney.com)
To state it simply, an “Edge” is nothing but a strategy that would give a positive expectancy when deployed over a certain period.
How do you know that your trading strategy has an edge?
For that you need to have a trading strategy, trading is a process and one has to learn the process. Professional traders have a predefined game plan as to when to enter, when to exit, what is the stop loss, what should be the risk per trade. There is no favourite time frame for professional traders, each finds their perspective which matches his or her trading personality. Some become intraday traders, some short-term traders & some positional traders.
What is consistent is that each tends to stick to only a single time frame, which is the one that works best for them. The professionals are ruthless in getting rid of losing positions. They basically work around various strategies that suit their personality and back test the same to arrive at a trading system which has a positive edge.
There are two ways to trade. The first one is a mechanical system and the second is a discretionary system. In a mechanical system, the trader’s judgement is not involved, since he or she has tested the mechanical system historically and is aware of the likely losses and drawdowns. Mechanical traders never have to make any trading decisions, they have a plan that tells them what to do in any potential situation. All they have to do is to monitor market activity.
On the other hand, discretionary traders have no fixed rules whatsoever. They make decisions based on the spur of the moment without a defined plan except their own idea of what works the best for them.
The big advantage of having a mechanical system over a discretionary system is that you don’t need to be an expert in economics, inflation, your system will automatically exploit price movements resulting from those trends.
How do you build a mechanical trading system which has a positive “Edge”?
For that you need to have a clearly defined entry rule, exit rules, stop loss and risk per trade, once you have defined the above you need to test it over historical data to see whether the system has an edge, or in other words does it make money or not. For that you need to back test the system.
Which brings us to back testing.
Let’s say you come up with a strategy for Index. Let’s call it a breakout strategy, which says buy when a stock/index closes above “N” days and short it when it closes below “N” days. The stop loss would be X percentage from the highest/lowest close.
Now you need to back test the above strategy in order to know whether the strategy has a positive edge or simply if it makes money or not. The first step while back testing is that you need to have a clearly defined entry rule, exit rules for losing trades and exit rules for profitable trades and your risk/stop loss.
Second is the sample size. Now this is where the challenge lies, ideally the strategy should be tested over a bull market, bear market and a sideways market as it should give you a good idea of uptrend, downtrend and volatility levels. Equally important is to know the number of trades generated by the system. Statistically speaking, the smaller the number of trades generated, the less reliable the test is. The more trades the test generates the more statistically reliable will be the result. Statistical reliability is important because it relates to the probability that your historical results will repeat in the future.
How do you evaluate your system results?
These are some of the key ratios that one needs to evaluate to arrive at the robustness of the system.
Total trades, winning trades (%), Losing Trades (%), Average Win, Average Loss, Risk: Reward, Profit Factor, Expectancy, Biggest winner, Biggest loser, Maximum drawdown, Greatest number of consecutive losing trades, Percentage Returns.
If after having followed the above-mentioned system criteria and the system ends up with a positive edge, that is it basically makes money, then your system has a positive edge.
So, you now have a system which has a positive edge.
But the story doesn’t end here. Having a system with a positive edge is solving just one part of the jigsaw puzzle. What are the other elements of this puzzle? I will discuss the same in my next column.
Follow the entire series here.
Kirit Manral is a professional trader, and has been running a mentorship program in trading since 2019, with mentees from around the globe. He can be found on Twitter at @KiritManral
