On Having an Edge

The first thing you need as a trader is a clear edge.

What do I mean by “edge?”

Edge comes from a market inefficiency that means you can buy cheap and sell rich on average over the long run.

Said differently, edge is positive expected value.

Expected value is the return you expect to realise from the edge if you could hit it an infinite number of times. Sophisticated people might describe it as the probability-weighted value of all payoffs summed over all possible outcomes.

The idea of positive expected value simply captures the notion that any single trade could go either way (even the best trading strategies have plenty of losing trades) but that, in the long run, you expect to make more than you lose.

The idea of expected value is crucial. I’ve noticed that most gamblers tend to understand it, but many traders do not.

For example, you sometimes hear traders say that by “letting winners run and cutting losses” they can create an edge. This is simply not true (most of the time). You’ll just end up with more (smaller) losses than (larger) winners. And, absent strong trend effects, the expected value is zero less trading costs.

“Option income traders” and “scale scalpers” often try to do the opposite. They create structures with a high win rate. But in doing so, they concentrate risk into the tails, meaning that the few losses they have are likely to be very large.

This has not created an edge—it has created an asymmetry in which the frequent wins are small and the infrequent losses are very large.

Again, all things being equal, the expected value is zero (less trading costs).

So you need to have an edge – something with positive expectancy.

And you really need to have some idea why it has positive expectancy. It isn’t enough to have a profitable backtest. You have to have an idea of why it makes money.

Traders can certainly make money without a clear idea of why they have an edge. For example:

  • A trader that trades small caps from the long side is likely mostly getting paid because of the equity risk premium and size factor – whatever they think the source of their edge might be.
  • “Option income” traders may think that their edge comes from their structures and take-profit rules – but their edge is that they are net sellers of equity index options and, in particular, OTM puts. They’re harnessing the volatility risk premium.
  • Mean-reversion “scalpers” and “spreaders” are getting paid mostly for providing liquidity to the market.

So you don’t need to understand where your edge comes from to make money. But it helps enormously if you do:

  • You will trade more simply.
  • You will trade more robustly.
  • You will remain more humble.
  • You will sleep better at night because you’re not wondering whether to turn your strategy off based solely on its recent returns.

Once you have an edge and you understand where it comes from, you have to exploit it in a way that lets you keep your money. We would call this risk management or portfolio construction.

Trade Like a Quant Bootcamp is a course on the fundamentals of getting an edge and exploiting it in a sensible way. Find out more, and sign up for the free mini-course to give it a test run here.

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