A trading edge gives you an advantage over the other players in the marketplace. You find trading edges by trading real money, getting experience, by walking and brainstorming, being systematic, reading websites, and having contact with other more successful traders.
How to find trading edges in the markets is crucial for surviving as a trader. The financial markets are a competitive place where amateurs and beginners are easy prey for the vultures further up the food chain. In this article, we look at trading edges. What is a trading edge? How do you find an edge in trading?
There is an ecological system in the marketplace, just as there is an ecological system in nature. You better understand the markets’ ecology and ensure you don’t get eaten to end your trading career prematurely. It would help if you looked for trading edges in the markets to survive. What is a trading edge, and how do you find one?
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 different from a trading strategy. A complete trading strategy involves more than just an edge.
Before you read on, we’d like to inform you about our paid subscription, Trading Edges. Every month, you get a trading edge in your mailbox, including code for Tradestation and Amibroker. Read more about our memberships here.
What is a trading edge?
A trading edge is a positive statistical expectancy in trading. Having an edge means that you have the probabilities in favor of a positive outcome each time you take a trade. It’s the most important factor in trading.
By making use of a mechanical approach that allows us to backtest and verify the strategy on historical data, we can make sure that we, at least historically, have had an edge. For instance, the curve below shows an example of a profitable strategy.
Here is a graphical example of a trading edge in trading:
The green dots show when your equity sets new highs, and clearly, this trading edge has worked well in the past!
To illustrate what an edge means in trading, we’ll use a casino as an example.
The game of roulette is skewed to be profitable for the organizer. As you might expect, this advantage is achieved by having a green zero, whereas all other markings are red or white. This small detail gives an expected win rate of 51,4% for the casino, which is enough to make it a profitable business venture.
Still, a casino may have several losing days each year, but in the long run, it will even out, and come closer to the calculated win rate.
In order to trade and make money long-term, you need to make sure that your trading strategy has an edge, meaning that you have the probabilities on your side. Otherwise, you’re simply doomed to fail in the long run.
Here is another example of an edge:
Let’s say that you have a dice with six sides. You’ll make $1 each time the dice show 3,4, 5, and 6 and lose $1 if it shows one or two.
Given that you get 1000 dice rolls, would you dare to risk everything you own?
Sure you would! The odds are nothing short of fantastic, and you certainly do have an edge!
To succeed, you need a good trading strategy with a positive edge. This is perhaps the most important aspect of profitable trading, and many fail simply because they don’t have it!
However, before you start trading, you should sit down and think about this:
What is your edge in trading?
Short-term trading is very much like a zero-sum game. Someone must either lose or gain what you make in profits or losses in the short term. How are you going to make money? How is your edge compared to other traders? Other traders with an edge might take your capital from you.
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 a statistical edge is vital to generating profits in the markets. We believe there are many misconceptions about an edge, and traders have their own definitions, perhaps rightly so.
The trading edge is based on something that shows better returns than the average returns. We can say it’s a trading set-up based on quantified strategies. It’s a statistical advantage based on historical backtests. Backtesting requires a trading platform to simplify testing (a trading platform is an advanced calculator).
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 becoming more difficult. Having sophisticated software or computers is no longer an edge, as it’s becoming more of a commodity for all players.
Most 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.
Please also keep in mind that a trading edge does not necessarily have more winning trades than losing trades. It depends on the gains per trade, not the winning trade percentage.
The good news is that you don’t need any Ph.D. or any degree to find trading edges. Quite the contrary, you can come pretty far just by sticking to simplicity as an individual trader.
On this website, we have published many free trading strategies built on “simple” trading edges. We at Quantified Strategies believe in simplicity. You don’t need an advanced mindset to succeed!
What is an example of a trading edge?
An example of a trading edge is when the stock market is down on a Monday, the returns over the next days of the week are much higher compared to Mondays when the market is up. This is a very good statistical edge to start from to make a profitable trading strategy.
We show you a detailed example further down in the article.
We have provided plenty of free trading edges on the website. For example, the example above about down Mondays we have as a complete strategy. You find it here: trading strategies for sale.
How long does a trading edge last?
It’s impossible to tell how long a trading edge lasts. It lasts as long as it is not “arbed” away, becomes too obvious, or the market structure changes.
For example, from 2001 until 2018, we traded opening imbalances on NYSE and Nasdaq. But the market structure changed, and the trading edge gradually disappeared – the window of opportunity became smaller.
Likewise, seasonal strategies normally disappear after a while.
What is a top trading edge?
A top trading edge is both profitable and complementary to your other edges. Even small edges might be very useful as long as they are not correlated to your other trading edges.
For example, a trader edge that is useful for your friend might not be useful to you because it does not add diversification. The composition of your trading edges matters.
Trading edge vs. trading strategies
A trading edge is not the same as a trading strategy. A trading edge deviates from the averages and can become a complete strategy, including variables for both when to buy and when to sell. Additionally, it would be best to think about money and risk management.
Let’s look at two examples to better illustrate what we mean by trading edges:
Trading edge example
If you look at the return for the S&P 500 per trading day of the month, you will notice slightly better performance at the end of the month and at the beginning of the month (compared to any other period of the month). There could be many reasons, but we will not delve into that.
Let’s do a straightforward test in Amibroker (read here for why we use Amibroker – we recommend using a trading platform to save time in the long run). We test the following trading rules:
We buy the S&P 500 (SPY) on the fifth last trading day of the month and sell at the close of the third trading day of the new month.
The average gain in SPY (S&P 500) from the fifth last trading day of the month until the close of the third trading day of the new month is 0.64%, with dividend reinvested. This is much better than any random period.
The equity curve of 100 000 invested in SPY (the ETF for S&P 500) in 1993 up until today shows a reasonably good equity curve:
The return is a solid 0.64% per trade, which equals a 7.4% annual return compared to buy and hold’s 10.1%. It doesn’t beat buy and hold, but we have to consider that the strategy is only invested 33% of the time. If we adjust for that to find the risk-adjusted return, we get 22%.
Compare this to the accumulated return by NOT being invested during those seven trading days:
The annual return drops to 2.5% despite being invested twice as long as in the first example. The performance and metrics for the second trading idea look pretty awful.
The turn 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.
The mean reversion trading edge in stocks
For over two decades, the stock market has shown strong mean-reverting tendencies. An opposite reaction has usually followed any sharp fall or rise. That is 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:
- The internal bar strength indicator (IBS)
- RSI(2) on Nasdaq (QQQ)
- How to create a mean reversion trading strategy
Please note that mean reversion only works for the short-term, i.e. just a few days.
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. You can make this edge into a trading strategy by selling losers and buying winners. It would help if you found 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 and 12 months but not for shorter or longer periods.
A straightforward momentum strategy is tactical allocations between the S&P 500 (SPY)and long-term Treasuries (TLT):
How to find trading edges in the markets
You find trading edges in the markets by trading real money to get experience, walking, brainstorming, being systematic, reading blogs, reading books, and working hard.
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 more manageable than trading strategies. Below we give some recommendations on how to find trading edges and ideas in the markets:
Generating ideas is much easier when you have traded real money and done backtesting for years. You know what to look for, and more importantly, you know your trading style and personality and your limitations. To find the edge, requires a certain skillset and that requires experience.
Thus, when you start, your only goal should be to survive.
Trade real money
Paper trading will never get you anywhere, although it serves a useful purpose, especially for beginners. You find edges mostly by trading real money.
Yes, you need to paper trade any new strategy you develop before going to live trading. But to see and “feel” what you are doing, you need to feel the joy of gains and the pain of losses.
Pull up some charts and look at patterns and movements. What happens after a big move? What happens after a surge in volume? What happens in commodities after a big move in the USD?
All truly great thoughts are conceived by walking.– Nietsche
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 into your brain is a perfect break-up of the trading routine.
Many studies demonstrate that walking increases creative senses. It doesn’t even only apply to outdoor walking: walking indoors on a treadmill serves the same purpose. Thus, it’s the process of walking that helps you, not the environment. The effect even extends to when people sit down to do their creative work shortly
We strongly advise reading the research paper by Opezzo and Schwartz called Give Your Ideas Some Legs: The Positive Effect of Walking.
(If you can’t go for a walk, breakthrough ideas in showers are also surprisingly effective – reported by 30% of people surveyed.)
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.
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 if you want to trade with an edge.
You need a trading journal. Read here for why you need a trading journal.
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 paid services to do all your thinking. 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.
Read books and blogs (this one, for example)
Just like websites, we believe reading books is better because they are usually more in-depth.
We have plenty for free if you are looking for a robust and profitable trading strategy.
Test ideas frequently
Perform backtesting of ideas at least several times per week. Testing is yet another way to generate ideas to start trading with an edge. You might suddenly discover something you were unaware of, and you 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 entirely 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.
FAQ about the trading edge
We receive emails about the trading edge pretty often. In this section, we address some of the issues that we are often asked about:
How to find your edge in trading?
You find your edge in trading by knowing your trading style and personality and adapting your edge to your goals and personality type. A trading edge that suits your friend Mike might not be very useful to you. For example, Mike might handle a drawdown of 30% well, while you might have abandoned the strategy a long time before that.
What is an edge in forex trading?
An edge in forex trading is when you have a positive expectancy in your trading – you have the odds of winning on your side. An edge in forex trading is the same as in all forms of trading. That said, a good forex edge is one that is both profitable and adds diversification.
How do you get an edge in forex?
You get an edge in forex by backtesting or keeping detailed records of all your trades. If you are not systematic, you are unlikely to find a trade edge or succeed.
We believe there is only one way to determine whether you have a statistical trading edge in forex: backtest. By the way, this applies to any market, whether forex, crypto, or stocks.
How do you find an edge in stocks?
You find an edge in stocks by backtesting or keeping detailed records of all your trades. If you are not systematic, you are unlikely to find a trading edge or succeed.
We believe the best edge in stock is the overnight edge. Likewise, mean reversion trading edges have worked well in stocks over the last three decades.
How many trading edges do you need?
You need many trading edges to succeed in trading. You can add trading edges if they contribute to the overall results. Typically, you must add strategies that don’t correlate to the existing edges and that are complementary.
Correlation is a very underrated aspect of trading. Even less good strategies can be beneficial if the correlation is low. We have covered this in many previous articles:
- What does correlation mean in trading? (Trading strategies and correlations)
- Uncorrelated assets and strategies – benefits and advantages (examples and backtests)
- Does your trading strategy complement your portfolio of strategies?
- Why build a portfolio of quantified strategies (including two strategies)
How do you find a trading edge in the markets?
Finding a trading edge in the markets is a multifaceted process that involves a combination of strategic approaches.
Engage in real-money trading to gain practical experience and a deeper understanding of market dynamics, is by far the most important. The more time you spend actively trading and analyzing market movements, the better equipped you become at recognizing patterns, understanding market behavior, and identifying potential edges.
Second, systematically test your trading ideas and strategies. Keep a detailed log of your backtesting results, including entry and exit points, risk management strategies, and overall performance. The more systematic you are, the better.
How can I create a mean reversion trading strategy?
Creating a mean reversion trading strategy involves understanding and capitalizing on the tendency of asset prices to revert to their historical average over time.
Mean reversion is a statistical concept suggesting that, over time, the price of an asset will move towards its historical average or mean. Look for assets that have experienced significant price movements, either to the upside or downside. Overextended moves may indicate an opportunity for mean reversion, as prices are likely to revert to a more sustainable level.
The stock market is the most mean-reverting asset, and bonds tend to revert to the mean. We have not been successful in finding any mean reversion for commodities.
What is the EDGE ratio, and how is it calculated?
The EDGE ratio, short for Edge Ratio, is a metric used by traders to assess the effectiveness of a trading strategy by quantifying how much a trade goes in the trader’s favor relative to how much it goes against them. It’s a kind of trading edge, and the formula and concept are pretty simple but smart.
It serves as a measure of the trader’s edge in the market, indicating whether the strategy has a positive expectancy.
The EDGE ratio is calculated using a straightforward formula: Edge Ratio=Average Gain per Winning Trade/Average Loss per Losing Trade.
How to find trading edges in the markets – conclusion
How to find trading edges in the markets is not easy and requires work, brainstorming, and a lot of backtesting.
However, a trading edge is not the same as a trading strategy: a trading edge is where you start to develop a trading strategy.
You need to be creative, adaptive, and systematic to find market trading edges. You must get experience, search for help from other traders, keep a detailed log of your backtesting, read websites, and make sure you trade real money, preferably so small that you survive the learning period when you start.
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. You need detachment from money to avoid being fooled by trading biases.