Few concepts in trading are as poorly understood as that of having an “edge”. In a literal sense, the idea of edge–in trading, as in poker–means that you have a skill and strategy that provides you with a non-random, probabilistic advantage over other players. Often, however, traders refer to an “edge” if they believe they have unique insights into markets, if a strategy has worked recently, or if a strategy is copied from someone believed to be successful.
Based on successful traders and portfolio managers I have worked with, I would argue that “edge” comes at the intersection of three factors:
1) What You Are Good At – A true edge, in finance as in sports, has to be grounded in your unique talent. Having a talent may not, in itself, provide an edge, but it is difficult to imagine possessing an edge without a distinctive talent. One trader I’ve worked with is unusually social and outgoing and is quite good at reading other people. He talks with many market participants all day long and obtains an unusually good feel for how people are positioned, what they are thinking, etc. He can also sense changes in their tones of voice and levels of conviction. Many times, he can identify when they are shifting views before the shift has even occurred. That social talent has also helped him build an effective team of analysts, who he has also learned to read quite well.
2) Who You Are Making Money From – A genuine edge has to make conceptual sense. It can’t just be a pattern (“setup”) that has recurred in the recent past. Anyone can backtest 20 patterns and find the one that tests as statistically significant at the p=.05 level! A true edge comes from understanding other market participants and how they behave, so that you can profit from their activity. For instance, perhaps you’re trading a meme stock and understand how retail traders identify and trade with momentum. Perhaps you’re trading earnings news for a stock and understand how investors respond to beats and misses. Perhaps you’re trading reversals in markets and understand how trend-followers behave. The edge, in markets as at the poker table, comes from knowing who is at the table and how they behave.
3) How You Develop Your Skills – The reality is that someone could have a talent and could learn about tendencies of other market participants and still not make money if they haven’t developed the trading skills needed to implement the conceptual edge. Skill development comes from repeated experience guided by corrective feedback, a process known as deliberate practice. Even after you identify valid patterns in markets, how do you size trades based on those patterns? How do you structure the trades to maximize reward relative to risk? These are skills that need to be honed. Many traders fail because they do not follow a systematic process of skill development.
If you understand the three components of edge in trading, you’ll appreciate how silly it is for market gurus to tout “setups” that make money. It’s like someone telling you successful pass plays on a football field. Unless you actually develop the skills of a quarterback, understand your opponent, and implement those plays in ways that utilize your team’s strengths, those “successful plays” will fail miserably. It’s not as easy as simply trading with discipline or trading your personality. Success in the trading business is like any entrepreneurial success: it requires talent, passion, objective opportunity, and the ability to learn from experience.
The ABCD of Trading Success