What You Need to Know to Develop and Maintain an Edge
Your edge is your best weapon in trading. It’s where you develop a system that produces a profit in the long run. Without an edge, it’s impossible to make money. You'll either lose your money or just stay stuck, never really moving forward because you don't have the odds in your favor.
If you’re serious about turning trading into an income, your edge is the centerpiece that holds everything together. It’s crucial to be constantly developing and improving it. Yet, many people, (including some popular trading figures) get a lot wrong about this critical aspect of trading.
Here’s what you need to know about developing and maintaining an edge:
The House Always Wins
The markets have proven to be a formidable opponent. Analyst after analyst has tried to predict what it’ll do next, but none of them end up being right consistently. The markets are unpredictable and chaotic. Price movement is random. The only serious way we can extract consistent profits from this unstable behemoth is to trade like a casino.
Casinos make tons of money because they have a known edge. In all of the popular games like blackjack and roulette, the casino has a slight advantage over the players. In roulette, the casino's edge comes from the green zero pockets. When the ball lands on these two pockets, the player loses.
In reality, you only have a 47.37% chance of winning, not 50%, because the zero isn't red or black. With thousands of players over time, this small percentage difference tips the balance in favor of the casino, ensuring they make a huge profit. Very simple, but very lucrative.
If casinos had no edge, they’d eventually go bankrupt. If too many players win too much money, they wouldn’t have enough to pay. With an edge, they always win in the end, so they’re able to stay in business.
The same concept applies to trading. You might have a few big wins, but if you don’t have an edge, you’ll eventually go bankrupt. Bad events are bound to happen eventually, and all that time you spent in the market will be a waste. To avoid getting into this situation that affects so many traders, let’s see how you can maintain an edge and keep the odds in your favor:
Backtest, Backtest, Backtest
The future is always uncertain. We have no idea if our edge will keep working or not. All of our decisions are made on incomplete information. That being said, there are a few things we can do to determine how strong and robust our edge will be.
This is why you should backtest as much as possible. Backtest in 2020, 2008, 2013, 2002, 1996, 2017, and more. Backest it in bull markets, bear markets, and choppy markets. Backtest it everywhere. This will give you an idea of how well it holds up in all market conditions.
Lots of strategies work great in bull markets but fall apart in sideways markets and bear markets. These types of strategies are not sustainable. All that time spent trading and earning money, just to give it all back - like a bankrupt casino. This is what we’re trying to avoid.
We want steady and sustainable growth, as much as possible. If your strategy manages to hold its ground in most of these conditions, it’s a reliable edge. If it can survive the 2008 crash, the dot-com bubble and the 2020 crash, it probably can handle whatever comes at it in the future. As long as your downside is protected, your upside potential is unlimited. Remember, you can’t trade if you have no money in your account.
Calculate Your Edge
Your edge comes from two aspects of your strategy: your win rate and average win/loss. We can calculate it with a simple formula:
If we have a win rate of 55%, an average win of $150, and an average loss of $100, let’s calculate our edge:
(0.55 x $150 + 0.45 x -$100) = $37.50
This means we make $37.50 per trade, on average. Over 1000 trades, this is a profit of $37,500. If you take 4 trades per day with this strategy, this is how much you can expect to make in a year.
This is how you must approach your strategy. You roughly know how much you’ll make, depending on market conditions. You have lots of data from backtesting different periods, so you know how your profits and losses are affected by different events.
You know you’re not going to make $100,000 in a single trade and you’re not going to lose your whole account in one either. There is no guesswork or excitement involved. Just like a casino, you know exactly what your edge is, and you just let it play out. You don’t see a casino get emotional over one loss or constantly change the rules of their game. Know your edge, trade it well, and let the profits roll in.
Disclaimer: Investing in stocks, bonds, futures, options, and other securities carries significant risks. Some or all capital may be lost. With leveraged instruments, losses may exceed initial capital. Past performance of a security does not guarantee future results. Any content from this newsletter should not be taken as financial or investment advice, but for informational and entertainment purposes only. This newsletter simply shares my personal opinions and notes. Consult with a registered financial/investment professional. This newsletter and its authors are not licensed financial/investment professionals. By reading and using this newsletter, as well as any other publications, you are agreeing to these terms.