Trading Edge – What Is It And How To Find The Best Edges? – Backtest, Examples And Strategies For 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 to find an edge in trading?

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. 

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. 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 not the same as 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:

What is a trading edge?

Before you start trading you should sit down and think about this:

What is your edge in trading? How are you going to make money?

Short-term trading is very much like a zero-sum game. What you make in profits or losses, someone 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 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.

We define a trading edge as something that helps you build a complete trading strategy. The trading edge is the core of your strategy and where you start when backtesting strategies.

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 getting 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 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 not necessarily has 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, as an individual trader, you can come pretty far just by sticking to simplicity.

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!

• Simple Vs Complex Trading Strategies: The Simpler The Better

Trading edge vs. trading strategies

A trading edge is not the same as a trading strategy. A trading 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, it would be best if you did 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 trading 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, 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):

• The average gain in SPY (S&P 500) from close to close any day of the month is 0.04%, with dividend reinvested. If you 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 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 on 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:

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

The return is higher in the last graph, but that is simply because you spend a considerably more time in the market. The price you pay for that is a substantially more significant 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):

• End of month strategy in the S&P 500

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)
• MACD-histogram
• 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.

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 you can make 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 1-12 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):

• Monthly momentum in SPY and TLT

How to find trading edges in the markets

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:

Get experience

When you have traded real money and done backtesting for years, generating ideas is much easier. 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 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?

Start walking

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
after.

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.)

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 if you want to trade with an edge.

You need a trading journal. Read here for why you need a trading journal.

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 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 are good, we believe reading books perhaps is even better because it usually goes more into depth.

If you are looking for a robust and profitable trading strategy, we have plenty for free.

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 that you were not aware 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 pretty often emails about the trading edge. In this section, we address some of the issues that we are often asked about:

What is an example of a trading edge?

We have provided plenty of free trading edges on the website. For example, we would like to use the overnight trading edge as a good and solid one.

How do you get an edge in forex?

There is only one way to find out if you have a statistical trading edge: you need to backtest. This applies to any market, whether forex, crypto, or stocks.

How do you find edge stocks?

Again, we believe the best edge in stock is the overnight edge. Likewise, mean reversion trading edges have also worked well in stocks over the last three decades.

What is EDGE ratio?

This ratio shows how much a trade goes in your favor contra how much it goes against you. It’s a kind of trading edge and a pretty simple formula.

Edge Ratio or E-Ratio measures how much a trade goes in your favor.

How many trading edges do you need?

You need many to succeed in trading. You can add trading edges as long as they contribute to the overall results. Typically, you need to add strategies that don’t correlate to the existing edges.

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 to find trading edges in the markets – conclusion

A trading edge is not the same as a trading strategy: a trading edge is where you start to develop a trading strategy.

How to find trading edges in the markets are not easy and requires work, brainstorming, and a lot of testing.

To find trading edges in the markets, you need to be creative, adaptive, and systematic. 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 so 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.