I received an interesting email from a friend who is doing a survey. In that email, he asked a few questions about trading. As I thought about these, I decided to treat them as writing prompts, and am sharing some answers with you. This part 1 of 2, and I’ll be back soon with some thoughts on risk, psychology and homework!
What is an edge in trading?
To me, a trading edge means that when we see a condition or conditions in the market, the market will evolve in some non-random way over some defined period of time. That’s a convoluted sentence, but I’m being deliberately precise.
One of the common definitions is that an edge is “a higher probability of something happening than something else”, but this is not correct—trend following approaches might have a very low hit rate or win ratio, not at all saying there’s a higher probability of something, but the magnitude of the move, if correct, is much larger. This is not just semantics—it’s important to think about these things with precision because we can’t get stuck in a mode of thinking that it’s just about something being more likely to happen in the future than something else. This is often true, but what about edges that deal with volatility, relationships between two markets, or unlikely tail events?
To my way of thinking, randomness is the “enemy”—if something is random we can’t make money with it. If a market is truly random, then we’re screwed—no edge is possible. If the market is not random but we are using tools that are random (i.e., have no edge) then we are screwed. It’s all about having that edge. (And I hope I know something about this as my book in progress is called The Trader’s Edge!)
What is “the hard right edge” and what don’t people understand about it?
This colorful term refers to the right edge of the chart, trading a chart in real time, as the bars evolve on the chart. This experience is very different than looking at a historical, completed chart. When we look back at a chart, all kinds of biases jump in and we find analysis much easier than it is at the hard right edge of the chart.
List the main areas traders should focus on:
This is problematic because everything is important for a trader. There are some disciplines where you can get pieces of the skillset together and have some success, but not so in trading—unless you have all of this right, you’re probably not going to make (and keep) any significant money. The main areas are:
Making sure you actually have an edge. Be aware that most of what is sold to the public or discussed (with great confidence) in chat rooms and social media does not actually have an edge.
Making sure you can apply that edge. This sweeps all issues of methodology, psychology, financing, software, access, etc. into one bucket.
We can slice and dice this a lot finer, but we risk losing generality. (In other words, here’s a more detailed list, but some of these things don’t apply to some types of traders in some situations.)
- Having an edge.
- Structuring that edge into a trading plan.
- Executing the trading plan with correct size and risk.
- Knowing how to get into and out of trades in alignment with your edge. Basically, knowing what your edge does and how it works.
- Monitoring your (personal) performance.
- Monitoring the performance of the edge and adjusting as needed.
- Ongoing research to develop new edges.
- Doing the deep work on yourself to make sure you are ready to receive the success that this process can give you.
What is a trading methodology?
A set of things you do—a process—that allows all of the above to happen with some repeatability. That’s really what it’s all about: making this repeatable and as reliable as possible. The market has a long of randomness, even within the context of a strong trading edge, so the question comes down to what can you do to make your results as non-random as possible?
The key is, essentially, removing degrees of freedom or random junk you throw into the mix. A good example of a bad thing is a trader who randomly pulls up different indicators when considering a trade. There’s no way to know what indicators he will use or how he will interpret them, so this trader is just throwing darts. Contrast that with a trader who has a precise plan and executes that plan with discipline. Now, the plan may suck, but we’re going to be able to see that because he’s doing the same thing over and over. Once we know that, we can work to change the plan and this gets us back to my very first point: make sure you actually have an edge.
A trading methodology is not just a setup or trading pattern, and it’s not even that and some risk management rules. It’s a complete mindset and approach to trading and managing trades in the market.