I often quote Van Tharp while talking to clients and traders. He says “If you don’t have rules to trade, everything you do is a mistake.” I would like to further add to above quote “If you have rules to trade without an “Edge”, everything you do is a mistake”.
What’s the meaning of edge?
The edge here means a quantitative advantage of the trading system. It shows how much are you expected to make per trade over many trades. it can also be described as the expectancy of the system.
It’s simply what the average % return/per trade that you can expect to gain over many number of trades. For example we did 5 trades as per below details in a month & result is something like this;
The avg profit in the above table is our edge or mathematical advantage. Before you start to trade any system you should have a reasonable estimate about the performance of the system. It is only common sense to trade a system with a positive edge.
There is another way to calculate the edge of trading system. If we continue with the above trade distribution, we can see that there were 3 winners & 2 losers out of total 5 trades. Average Win was 5.35 % ( 6.17+5.39+4.5) & average loss was -2.05 % (-2.5+-1.6). Now lets plug in these data points into the following formula…
Expectancy = Average Gain * Winners – Average Loss * losers / Total Trades
= 5.35 % *3 – 2.05 * 2 / 5
= 16.05- 4.1 / 5
= 2.39 % per trade.
As you can see in the above formula that average gain is 2.39 %, same as the earlier method.
Why do you need and Edge ?
For any business to prosper, it has to have some kind of advantage over competition to be successful. For example, some may have pricing advantage, some may have unique product differentiation and some may have advantage over distribution or manufacturing.
Similarly, trading is no different. If you want to be a profitable trader or investor, you have to have some kind of edge or mathematical advantage as shown above, which you can exploit consistently.
Let’s take an example of Warren Buffett. What’s Buffet’s edge? Well, you don’t compound large capital over 20 % per year for over 50 years if you don’t have some kind of serious edge.
In fact he invests primarily into the businesses which have “moat” around them. Moat here simply is a competitive advantage or edge of the company over competition.
Most people lose money in the markets because they don’t have proper rule sets to approach the markets on daily basis. They will mostly rely on CNBC & their talking heads, Newspapers, brokers, relatives, friends & get lured by get rich quick schemes.
Having rules also is not sufficient if those rules are not properly backtested to have a positive edge. The only way to win in the markets on a consistent basis is to have trading systems with a proven edge & executing it over & over again over a long periods of time.
Just think for a moment. How are you supposed to compete with the likes of professional traders, FIIs, DIIs, Mutual funds and HNIs who have access to fast and accurate information, data and who have billions of dollars at their disposal without some kind of an edge? Your chances are very slim & that’s the reason so many people lose money in the markets.
What’s the edge of mean reversion traders like us?
Well, we need to first understand why do these edges exists. These profitable edges exists because of FEAR. When markets are falling & you are down heavily, you just want to get out of position because the pain is just unbearable. This creates mis-pricing and those who can buy these extremes have an edge.
We buy in to positions when there is a great deal of fear in the market place & people are scrambling for exit at any price. That’s our edge !