Tuesday, October 09, 2007

How Do You Know You Have A Trading Edge?

Once again, the comments to recent posts have been most enlightening. The topic for the present post came from a penetrating set of questions asked by NQ Trader in response to my "Wonderland" post.

NQ Trader was asking an epistemological question: a question about the state of our knowledge as traders. We often hear of trading edges, but how do we *know* we have an edge when we trade? How do we know that results aren't merely the result of chance?

It seems to me that there are two answers to that question:

1) Defining Edge in Terms of Backtesting - One tradition examines trading patterns over a historical period that includes a variety of market conditions (bull swings, bear swings, high volatility, low volatility) and determines whether the distribution of price changes following these patterns displays a positive expectancy (i.e., a non-random directional bias). Such an approach is most commonly seen in the development and testing of mechanical trading system with such software as TradeStation. The definition of edge is thus historically based. True, the future may not mirror the past, and care must be taken to not curve-fit historical tests. Still, the backtesting of patterns over market history has led to significant profits for a variety of quantitative funds.

2) Defining Edge in Terms of Trading Outcomes - Defining the edge of a discretionary trader is a somewhat trickier matter. The discretionary trader, by definition, is not relying upon fixed signals for trading decisions. Instead, he or she is reading market patterns from experience and acting accordingly. The edge of the successful discretionary trader is something akin to the edge of a highly successful athlete: it may be felt, but it is ultimately known only in retrospect. When we analyze a discretionary trader's results, we can see if the trader differs from chance in terms of the proportion of winning trades, the earning of profits, etc. For a trader who makes, say, 1000 trades, we can even conduct simulations and determine the probability that a random series of 1000 trades would achieve or exceed that trader's results. Indeed, by treating the discretionary trader as if he or she was a trading system, we can analyze results and identify an edge.

Speaking solely for myself and my own trading, I occupy a space somewhat between these two definitions of edge. I investigate historical patterns in the markets and factor those into my decision making. Ultimately, however, this factoring is discretionary and my decisions to enter and exit trades are made on a discretionary basis as unfolding market conditions dictate.

Let's take an example from the current market:

I tend to seek patterns with an edge by asking myself: "What is distinctive about the market's recent behavior?" I then test to see how the market has behaved over the past several years when that distinctive element has been present.

On Monday, for example, we made an inside day. I went back to 2004 in the S&P 500 Index (SPY) and found 119 occasions (out of 945 trading days) of inside days.

The day after the inside day, SPY averaged a loss of -.09% (51 up, 68 down). That's notably weaker than the average one-day gain of .06% (470 up, 356 down) for the remainder of the sample.

What happens, however, when the inside day follows a strong up day (as is the recent case)? It turns out that there have been 31 occasions since 2004 in which an inside day has followed a daily rise in SPY of over .50%. The next day, SPY has averaged a loss of -.26%, with only 7 occasions up and 24 down. That is quite a negative skew (which can be formally established with the use of statistical tests).

When I find patterns such as this--particularly multiple patterns pointing in the same direction--that provides a framework for thinking about the next day's trade. I then wait for the market open and see how the market is trading relative to value, how traders are hitting bids and lifting offers, etc. If I see signs of early weakness--buying that cannot, say, move the market above its overnight highs--I will act upon the historical pattern and try to profit from the edge.

Do I *know* I have an edge with such a trade? I may feel confident in my reading of the current day's trading patterns, and I may feel confident in the historical pattern I'm leaning on. Ultimately, however, the arbiter of whether or not I possess an edge lies in my trading results. What is the likelihood that those results could have been obtained randomly? That, it seems to me, is the gold standard.

If my results are consistent with those achievable by chance, then either I'm trading methods and patterns without an edge or my execution is erasing the edge contained within my methods and patterns.

In other words, we either have a logical problem (no edge to our methods) or a psychological one (inability to capitalize on an existing edge).

In the end, edge boils down to non-randomness, whether we're testing historical patterns or present market performance--and whether we're testing mechanical systems or discretionary traders.


Historical Patterns as a Heads Up in Trading