What is your Edge?

You may notice that there is a distinct lack of indicators or in fact anything remotely high-tech on my charts as I read them.  I do respect Technical Analysis to the extent that market participants anchor price expectations according to past price behaviour and I often employ simple patterns of compression and expansion, support and resistance or the occasional trend channel in my trading analysis.  I do not, however, consider my “edge” to be in Technical Analysis and I am happy to leave it to the systematic program traders with back-testing skills to utilise mathematical relationships and correlations inherent in the market.  This brings us to an important point.  To have any chance of succeeding as a trader you really need to consider what your edge is.  I am a complete ludite when it comes down to programming or back-testing strategies and so there is no point in me trying to compete in this space.  Likewise, for those of you trading on laptops from the poolside, most probably through spread-betting companies, I can tell you that your edge is not in intra-day trading off of the 15min chart or less.  This is the domain of market depth scalpers with years of experience of reading the ladder or using spread machines.  Speed is of the essence when it comes down to intra-day scalping and even in this space we are seeing traditional forms of scalping give way to the emergence of high-frequency algorithmic models using complex strategies such as flash-orders and micro-structures that are executed in nano-seconds through servers located next door to the futures exchanges.  If you are insistent on trading intra-day (I know I have been prone to scalping one side of the order book if I have a strong directional bias) then you should really stick to the highly-liquid haven of Forex rather than the shark infested waters of exchange traded derivatives. 


As an off-floor speculator, therefore, you should really be looking at the bigger picture and thinking about what your edge is.  This doesn’t mean trying to trade off of a deductive fundamental hypothesis regarding the state of the economy as many Retail trading outfits with their catchy slogans will lead you to believe.  How can you really have an edge in this space when you are competing with entire institutional research departments? Even then it is no secret that the market rarely responds logically to the release of underlying fundamental data.  This is because often it has already been discounted in the price (for various disconcerting reasons) and as a “liquidity event” is simply giving the big players an opportunity to re-position.  Hence the old adage: “Buy the rumour. Sell the fact”.  So where does this leave me you may ask? Well I strongly believe that one of the best ways of trading is as a speculator who doesn’t have to commit any money to the market unless the best opportunities arise.  This is both a timeless strategy based on the unchanging nature of mass physiology and herd-mentality in the market, as well as being far less stressful then other forms of trading.  If you read books by various successful traders including the Market Wizards collection, then it will become apparent that you do have a real edge as a speculator and with patience and discipline you can make money.   As Larry Hite says in Market Wizards:


“In any situation or game, you can define a positional advantage for any player – even the weakest one.  In trading, you can define three categories of players: the trade, the floor, and the speculator.  The trade has the best product knowledge and the best ways of getting out of positions.  For example, if they are caught in a bad position in the futures markets, they can offset their risk in the cash market.  The floor has the advantage of speed.  You can never be faster than the floor.  While the speculator doesn’t have the product knowledge or the speed, he does have the advantage of not having to play.  The speculator can choose to only bet when the odds are in his favour.  This is an important positional advantage.” (2006)


So how do we specifically relate this to trading strategies for the speculator? Well, I think many of the more traditional axioms of trading apply to speculators more than any other form of trading.  These would include; discipline, patience, risk-reward and money management to name but a few.  There have been numerous texts written on the importance of trader psychology, patience in waiting for high-probability trades and discipline in cutting your losses.  These are demons the individual trader will have to address, but in terms of my trading strategies, I can’t stress enough the importance of risk reward.  You have to get the odds in your favour and shouldn’t be taking any trade with less than 1:1 risk reward as a bare minimum.  With 1:1 risk reward you will only make money in the long-run if your accuracy is more then 50% and even then you will not grow your account very quickly.  With a risk reward of just 1:2 you can significantly under-perform 50% accuracy and still make money in the long-run.  Various studies have been done that would even indicate that a totally random entry strategy with 1:2 risk reward can be profitable!  Interestingly, however, this was only the case on a larger timeframe when reasonable risk parameters were used for individual trades.  As you go down the timeframe to the intra-day minute by minute price behaviour, the ratio of noise to direction becomes much higher and the risk reward ratios become skewed to the point of uselessness. This point is driven home by the legendary trader/fund manager’ess Linda Raschke during a presentation at a recent trader conference which can be viewed on You Tube http://www.youtube.com/watch?v=g1hs6-mr6PU.   


To summarise this point; As a speculator trading high-probability set-ups on a daily timeframe we should be able to take advantage of increased directional momentum and the massive benefits of risk-reward at the expense of other market participants.  Put simply, this is our edge and we should only be concerned with trading strategies that maximise this edge.  In my next article I will discuss some of the strategies and techniques that I use to consistently profit from the markets.