How To Find Trading Edges In The Markets (With Examples)

Last Updated on November 25, 2020 by Oddmund Groette

Having some kind of an edge in the markets is crucial to make money. The financial markets are a competitive place where amateurs and beginners are easy prey for the vultures further up the food chain. There is an ecological system in the marketplace, just as there is an ecological system in nature. You better understand the ecology of the markets and make sure you don’t get eaten to end your trading career prematurely. You need to look for trading edges in the markets to survive. What is a trading edge?

A trading edge is something that gives you an advantage over the other players in the marketplace. You find trading edges by trading real money and getting experience, by walking and brainstorming, being systematic, reading websites, and having contact with other more successful traders. 

The beauty of trading is that of creativity. It pays off to leave no stone unturned, and the more experience you get the better probabilities you have to find trading edges. We emphasize that a trading edge is not the same as a trading strategy. A complete trading strategy involves more than just an edge.

What exactly is an “edge”?

Short-term trading is very much like a zero-sum game. What you make in profits or losses, someones must either lose or gain, in the short-term. The derivative markets are a 100% zero-sum game: when you buy a contract, the other part of the contract makes the exact opposite returns from you. If you make a profit, he or she makes a loss. If you have a loss, the other part of the trade makes a gain.

Having an edge is vital to generate profits in the markets. We believe there are many misconceptions about an edge, and traders have their own definitions of what this is, perhaps rightly so.

We define a trading edge as something that helps you build a complete trading strategy. The edge is the core of your strategy and where you start when backtesting strategies. The edge is based on something that shows better returns than the average returns. We can say it’s kind of a trading set-up based on quantified strategies.  

You need to separate yourself from the other traders in the market, and thus you need to trade instruments and time frames where competition presumably is low. You can further employ exits and other tactics where you know you have some statistical possibilities of generating profits.

However, finding an edge in the markets is getting more and more difficult. Having sophisticated software or computers is not much of an edge as it’s getting more of a commodity for all players. Most of the traders and investors have access to the same tools of the trade, and thus it gets difficult to get a trading edge over the others. Thus, it’s your creativity that can help you generate trading edges.

The good news is that you don’t need any Ph.D. or any kind of degree to find trading edges. Quite the contrary, as an individual trader you can come pretty far just by sticking to simplicity. At this website, we have published many free strategies built on “simple” edges. We at Quantified Strategies believe in simplicity. You don’t need an advanced mindset to succeed.

Please also remember that a trading edge not necessarily has more winning trades than losing trades. It all depends on the gains per trade, not the percentage of winning trades.

Trading edge vs. trading strategies

An edge is not the same as a trading strategy. An edge is something that deviates from the averages and has the potential to become a complete strategy including variables for both when to buy and when to sell. Additionally, you need to do some thinking about money and risk management.

Let’s look at two examples to better illustrate what we mean by trading edges:

The end of month edge:

If you look at the return for the S&P 500 per day of the month, you will notice slightly better performance at the end of the month compared to any other period of the month. There could be many reasons for that, we will not delve into that.

Let’s do a very simple test in Amibroker (read here for why we use Amibroker):

  • The average gain in SPY (S&P 500) from close to close any day of the month is 0.04%, dividend reinvested. If you for example bought on the close of a Thursday, you would expect a gain of 0.04% by holding SPY until Friday’s close.
  • However, if you buy on the close on any day of the month 27 or higher, the average return increases to 0.11%.

Holding the S&P 500 from close to close any day on the 27th calendar day or later, yields a return that is more than twice as big as the average gain any random day. That is a pretty significant difference.

The equity curve of 100 000 invested in SPY in 1993 up until today on calendar days 27 or higher, shows a reasonably good equity curve:

The end of month anomaly is still working.

Compare this to the accumulated return by only being invested on calendar days 26 or lower:

Being invested on day 1 to 26 shows a significantly worse performance.

The return is higher in the last graph, but that is simply because you spend a considerable more time in the market. The price you pay for that is a substantially bigger drawdown.

The end of the month anomaly is not a trading strategy on its own. But it’s an edge that gives you an excellent starting point to develop a complete strategy with entry, exit, and risk management. Thus, a complete trading strategy is a bit more complicated than an edge.

Back in 2015, we developed a simple end of day strategy for the S&P 500 (SPY):

The mean reversion edge in stocks:

For over two decades the stock market has shown strong mean-reverting tendencies. Any sharp fall or rise has usually been followed by an opposite reaction. That is of course not a trading strategy, but it’s an edge you can develop into a strategy. A perfect example of such strategies can be found here:

Please note that mean reversion only works for the short-term, ie. just a few days.

Momentum:

Another edge could be momentum. Empirical research shows that stocks that have performed well in the past continue to perform well in the coming months. Opposite, stocks performing poorly continue to perform poorly. This is an edge that you can make into a trading strategy, by selling losers and buying winners. You need to find the correct time frame and which instruments to trade: how many periods to use as the lookback period, and how many periods as the holding period. History shows this has worked for periods between 1-12 months, but not for shorter or longer periods.

A very simple momentum strategy is tactical allocations between the S&P 500 (SPY)and long-term Treasuries (TLT):

How do you find trading edges?

Trading edges are not something you will find easily. Traders are secretive, and all traders will never share their best strategies. This applies to us at Quantified Strategies as well. If you make good money on a strategy, why would you share it and potentially ruin the strategy? Strategies that get too crowded, inevitably disappear. In the financial markets, you will get nothing for free. You have to develop strategies yourself.

Nevertheless, finding trading edges is easier than trading strategies. Below we give some recommendations on how and where to look:

Get experience:

When you have traded real money and done backtesting for years it gets much easier to generate ideas. You know what to look for, and more importantly, you know your trading style and personality and what your limitations are.

Thus, when you start, your only goal should be to survive.

Trade real money:

Paper trading will never get you anywhere. Yes, you need to paper trade any new strategy that you develop before you go to live trading. But in order to see and “feel” what you are doing, you need to feel the joy of gains and the pain of losses.

Start walking:

Walking and physical exercise is a very underrated way of generating ideas. If you are staring at the screen all day, taking a break to let the blood flow your brain is a perfect break-up of the trading routine.

Brainstorm:

The point of walking is to brainstorm and generate ideas. Most ideas will be foolish, but if you never test you will never find anything. Write down ideas when you have them. Always have a list of ideas that you are going to test.

By systematic:

Make sure you write down all strategies you test. Sometimes you find the missing link by looking at things you tested two years ago. Markets change and evolve, you as a person develop better skills as time pass by, and later you might learn a small detail that could turn randomness into a trading edge. Details are important.

Read websites:

Many websites have lots of trading edges without knowing it themselves, and many paid subscriptions are well worth their money. Please remember you should never expect any paid service to do all your thinking for you. That is laziness and a habit to get rid of. No matter what you do in trading, you must never outsource your thinking. Yes, you can expect to generate some tips, help and ideas, but ultimately you must do your own thinking and research.

Test ideas frequently:

Perform backtesting of ideas at least several times per week. Testing is yet another way of how to generate ideas. You might suddenly discover something that you were not aware of, and you simply learn more about markets by testing. This is of course a time-consuming process, but nothing comes easy in a competitive market.

Make sure you have contacts with other traders:

Two people always think better than one. We at Quantified Strategies have managed to be profitable for two decades, and the main reason is that we have been blessed with ideas from other successful traders. It’s unlikely that you will manage to generate enough trading edges completely on your own. One way could be to pay for face to face learning with traders you know have been successful in the past.

Be active on discussion forums. Be helpful to others, and you most likely get some help in return.

Conclusions:

A trading edge is not the same as a trading strategy: an edge is where you start to develop a trading strategy. In order to find trading edges, you need to be creative, adaptive, and systematic. You must get experience, search help from other traders, keep a detailed log of your backtesting, read websites and make sure you trade real money, preferably so small so you survive the learning period when you start out.

Last but not least, you need a real passion for trading. Money should never be an issue, it’s just a byproduct of your thinking.

 

Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.