A Bit More on Edge

Feb 6, 2008: 3:07 PM CST

Recall from my previous post entitled A Little Edge is All You Need that the Vegas style casino games enjoy a very small edge to keep those millions flowing in each year. Let’s look a little more about how this relates to your own trading.

Without delving too deeply, there are two simple ways to create standard ‘edges’ in trading.

First, you can create a probabilistic edge, where your expected win ratio (number of trades that produce wins is greater than your number of losing trades) is greater than 50%. There are a variety of strategies that can be summed up as “High Accuracy” trading, which try to take advantage of this concept.

Second, you can create a monetary or outcome edge, where your expected profit per winning trade is higher than the expected monetary loss on a losing trade. Trend following or position trading strategies often capitalize on this type of edge.

As a general rule, high accuracy strategies appeal to newer traders because it feels wonderful to be right, and these strategies have you frequently “ringing the register” while booking smaller profits.

As another general rule, professional traders understand that the power of edge in trading is best when the win ratio and the monetary edge are both in factor, but they also realize that such situations or strategies are also very rare. Typically, one has to sacrifice one variable for the other in creating a long-term viable system with an edge to the trader against the market (or other traders).

Although not on a strict continuum, it seems that when you adjust one variable (increase win rate or accuracy), another variable (profits per trade or size of losers) suffers, creating a “zero balance” (zero edge outcome) or worse.

Consequently, when you attempt to raise profits per trade and employ trend-trading strategies, you often degrade the win ratio because of frequent whipsaws before you join a true trend. While the trades that win make significantly more money, you must suffer a win rate closer to 50% or likely lower.

The concept of “RR Spread Risk” helps to ensure a degraded win rate. By this I mean the “Risk to Reward Spread Risk” in that if you seek a four to one reward to risk ratio (you play for an $8 target but risk $2 on a stop loss), then normal volatility in the market will ensure that your $2 stop is tagged far more frequently than your $8 target. Although you are making more when you have a valid and winning outcome from a signal, the market will move $2 against you more frequently than it moves $8 in your favor (assuming all else is equal).

I will discuss more in future posts, including how to define and measure edge in your trading activities, but for now, think about these concepts and how they relate to your own trading activities.

Comments Off on A Bit More on Edge

Comments are closed.