In a recent blog post, I made the statement (borrowed from Jack Schwager), that you must have an edge to be successful in the marketplace, and, if you don’t know what your edge is, you don’t have one. This, of course, prompted the logical question from a few readers: “how do I know if I have an edge?”
Before I answer, I need to start with a disclaimer: There are a lot of ways to make money in the marketplace. I’ll try to be as inclusive as possible in this answer, but just realize that everything here will be somewhat biased from my own perspective as a primarily technical trader who uses hybrid systematic and discretionary techniques. I’ll point out some of the places where I’m reasonably sure an edge does not exist, but, undoubtedly, there are things that I’m missing here, too.
1. Your edge has to be realistic. There are many arcane and silly approaches to the market. Sadly, it’s not easy to avoid this stuff because it is everywhere. In fact, some certification programs focus on a lot of the arcane stuff, so we have an army of technicians with letters after their names who talk about, say, the 161.8% Fibonacci extension, or argue over wave counts. Prices in financial markets are driven by buying and selling decisions people make. I’ve been down the “mysteries of the Universe/probing the Mind of God” rabbit hole myself, earlier in my trading career. So much of technical analysis is centered around sloppy and magical thinking. If your edge depends on this kind of stuff, you’re probably in trouble before you begin.
Also, being realistic means you must understand that trading returns are uncertain; you’ll have rich periods and lean periods. Your trading account is not going to be an ATM, and your edge may work for a while and then stop working. It’s not uncommon to see a trader make quite a lot of money, and then to enter a period where he cannot make money at all as market conditions change. Even if your edge is solid and stable, it will only be so within the bounds of probability, and those margins can be pretty fuzzy, indeed.
You have to commit to the work and commit to continually evolving as a trader. You have to commit to the process.
2. Your edge must fit your timeframe. Do fundamentals matter? Do short term movements, say on a 5 minute chart matter? How about relationships between prices in different markets? The answer, of course, is yes and no, depending on what kind of trader you are. If you are a short-term trader, focusing on fundamentals probably doesn’t make sense. (For one thing, how relevant can data that comes out quarterly be to a trade that lasts a few days?) If you’re a long term trader, you need to figure out how to filter out the noise. Your edge must respect factors that are relevant to your timeframe.
3. Your should be able to verify your edge statistically. This is a good news/bad news situation: you have to have some basic knowledge of probability and statistics to tell if you have an edge. There’s no way (that I know of) around that, but the good news is that the math is pretty simple. Even someone who is “mathematically challenged” can acquire the skills needed in far less than a year’s time, with a little work and focus. What you’re looking for is an understanding of the concepts behind statistical significance, but also some common sense, real-world application. Imagine I shuffle a deck of cards and deal them to you, and you find three red cards in a row. How surprising is that? What if the next ten cards are also red? How surprising is this now? Would you begin to suspect something about the deck? If I assure you the deck is fair and was fairly shuffled (and you know I’m not lying), what are the odds the next card is black? You should be able to do math like that pretty quickly and easily, or at least have some solid intuition about the answers.
As for backtesting, I think there’s a place for it, and it’s a topic I cover in some depth in my (completely free) trading course. There are also limitations, and you need to understand those, as well. The best way to verify your edge is to clearly define your rules, test them, and then out of sample or forward test them before committing real capital and risk. I could list a thousand bad ways to think you have an edge: relying on the authority of a guru, finding a simple pattern and not testing it, etc., but all of those ways would fail at this step. If you can’t codify and test your edge, I think it’s very hard to understand it. (Note that this applies to fundamental approaches as well.)
4. Your edge must fit you. We’re all built a bit differently. Some of us have widely varying attitudes toward risk, patience, emotional control, and many other aspects of our personality. I think there are many ways that most traders could trade successfully, but there are also many ways that just will not work. For instance, can you sit through 40% drawdowns that might last 2 years if you knew, with a pretty high degree of certainty, that you’d make money over the long haul? If not, then you shouldn’t be a long term trend follower. Can you devote every second of ever day to focusing on the market? If not, you can’t daytrade. Are you prepared for a 3-5 year learning curve, and do you have the capital (mental and financial) to sustain your learning through that time period? If not, then you probably can’t trade at all.
Good things happen when a trader, who is at the right stage of maturity, finds a system that fits him like a glove. So many of the struggles and problems he has faced will resolve themselves, seemingly effortlessly, but, of course, it’s the long years of work to get here that make it all happen.
Of these points, #3 is probably where most developing traders need to focus a little more time. It’s hard to have the confidence to execute without having a high degree of certainty that your edge is real–in fact, you shouldn’t have that confidence! Confidence in the wrong thing is a sure way to financial ruin in the markets. Knowing your trading edge, understanding it, is a critical step in trading successfully.