What Is a Trading Edge?
A trading edge helps you estimate the probabilities of a scenario, and shifts the odds into your favour to create a positive expectancy.
Why You Need an Edge
The common definition of having an edge in the markets, is having something that gives you an advantage over other market participants. This is partly correct, but it’s not the full picture.
There are two parts to having a trading edge:
- It gives you something consistent to estimate the probabilities, that’s the success rate.
- The edge has predictive power which can give you a positive expectancy.
What do we mean by positive expectancy?
Imagine you have a situation where your stop loss is 20 pips and your target is 20 pips. Without any other factors, one way we could estimate the probability of that situation is based on distance. We’d estimate the success rate at 50% - the distance either side is equal.
If your stop loss is 10 pips and your target is 30 pips, the probability of a profit is 25% and the probability of a loss is 75%. This is because there’s a shorter distance between the entry and the stop loss than between the entry and the target.
Let’s say we take 100 trades with $10 at risk for each trade in the last example:
In both of these cases, we don’t have a positive expectancy, the return would need to be profitable (with a margin of error) and we wouldn’t be profitable taking these trades. Even at breakeven, we’d be losing money due to transaction costs.
If we have an edge in the market, it allows us to use our edge factors to estimate the probabilities beyond just using the distance - assuming it has predictive power. Having some kind of predictive power means it puts the odds in your favour, and the probabilities are high enough to make a profit over the long-term.
For example, let’s go back to that second situation. The stop loss is 10 pips away and the target is 30 pips. Previously we had a 25% change of profit. However, let’s say our edge improves the probability estimate of the success rate to 35%. If we risk $10 per trade over 100 trades:
This time we made a $400 profit, those trades had a positive expectancy.
Another important point is that an edge also gives us something consistent to base probability estimates on, and something consistent to test and become more accurate with.