The Statistical Edge – The Most Important In Trading
In this lesson, we are going to take a look at the edge, and why it is such an important component of a trading strategy!
The Edge
In trading, a trading strategy is defined as a clear set of rules that dictate when to buy and when to sell.
When designing a trading strategy, you must make sure that you have an “edge”. Having an edge simply means that you have the probabilities in favor of a positive outcome, each time you take a trade.
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.
The Casino Example
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.
One More Example: The Dice Roll
Here is another example of an edge:
Let’s say that you have a dice with 6 sides. You’ll make $1 each time the dice show 3,4, 5, and 6, and lose $1 if it shows 1 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!
The Edge Is The Most Important In Trading
The most important thing in trading is to have a positive statistical edge, secondly, you need proper position sizing, and only third comes the behavioral aspect (see more later about all this).
Many traders start out without a statistical edge. Thus, they inevitably fail.
Conclusion
In order to succeed, you need a good trading strategy that’s based on an edge. This is perhaps the most important aspect of profitable trading, and many fail simply because they don’t have it!