A Little Edge is All You Need
In trading, we seek to identify small windows of opportunity where we expect one event to occur over another event, given that we can monitor our risk should something go wrong. Take a moment and think about how you define your trading edge and what it means.
An edge is simply nothing more than a situation where the probability of one outcome happening over another has tipped slightly to favor that one event. An edge does not guarantee an outcome, however.
There is no edge to a coin toss because both sides of a coin have an equal probability of landing face-up.
There is edge to a certain pairing of cards in poker when they are dealt.
There is also edge in the roulette wheel (in favor of the casino) because of the two green zero and double zero spaces. You may think that there is a 50% chance (like a coin toss) of the wheel landing on a red or a black space, but actually there is a 47.3% chance of either red or black coming up, giving a slight edge to the casino.
Red: 47.3%
Black: 47.3%
Green: 5.2%
When we add these up, and if we play the game in terms of a player betting between red and black all night, he could expect to lose 5.2% of his money by the end of the night, provided he made a sufficient number of bets. On the other hand, the casino could expect to gain 5.2% of all money wagered by the player due to the edge from the green spaces.
An article on roulette at Wikipedia showcases an excellent table of the odds of every possible event occurring in Roulette, and the house retains a 5.2% edge ($0.05) for every dollar wagered.
So what might this mean in your trading?
All you need is a relatively small edge and a large number (sample) of trades taken carefully with that edge to become a net winner as a trader. However, so many people do not realize that and create all sorts of errors and problems for themselves by taking trades with negative edge for them, for whatever reason.
There are many sources of potential edge in trading, such as the use of a combination of indicators, beliefs in price fundamentals, recognition of certain price patterns, recognition of a trend, recognition of a structural price component (such as an extreme, gap, or high volume reading), etc.
It’s rare than any one indicator will give you sufficient edge, but you have to know what your edge is before taking a trade.
You can discover the patterns you perceive as giving you an edge through back-testing, forward (future) testing, hand-annotation of charts, etc.
Stay tuned to learn more about how to discover you edge and how to ensure you are taking trades with the odds in your favor for that moment.
I think trading is similar, if not more, to the roulette odds (5% house edge) due to trading cost, market makers, execution speed, etc. I am sure there are tens of thousands other disadvantages as well for individuals such as technology, research, trading capital, emotional bondage, etc. So in order to have that “small” edge, it takes quite a big leap in some ways for individual traders. I am still learning to try to find that “small” edge myself. Thanks for your knowledgeable insights into the market.
Jsp, Thank you for reading and for commenting.
Traders believe that they have to be right all the time, and that pressure leads to intense stress. In reality, it doesn’t always have to come down to a percentage edge for traders, such as 51% winners to 49% losers. It can also come down to a dollar or mathematical capital won/lost edge in terms of how much one wins on the winning trades and loses on the losing trades.
Big name trend followers and funds may have win rates of 25% or less, but amass large profits because losers are cut relatively quickly and painlessly, while the winners produce outsized gains for months if not years.
But you’re right – execution costs and information fees/brokerage, etc cut into the statistical and financial edge of individual traders so it’s best to have as large as edge as we reasonably can.
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