Sunday, February 18, 2024

Where Does Trading Edge Come From?


It's been interesting returning from my sabbatical and rejoining the online world of trading.  So much noise, so much noise, and yet there are gems out there.  Kudos to the sharing of original research from Concretum Research.  It is a joy to find social media posts that share ideas and address our highest aspirations to understand and master complex realities.

There is an important relationship between trading edge and trading psychology.  Let's explore.

Consider three sources of trading edge:

1)  Directional Movement - We find patterns and relationships in markets that lead to the directional trading of an asset.  An example would be a breakout move that results from a news catalyst.

2)  Relative Movement - We find patterns and relationships in the movement of one asset relative to another one.  An example would be the relative value trading of rates, where we might expect the yield curve to steepen due to inflationary pressures in the economy.

3)  Absolute Movement - We find patterns and relationships in the volatility of assets.  An example would be an options trade that makes money if markets stay in a relatively quiet range after a volatile period accompanied by high options skew.

A rough analogy would be the different ways of scoring of a basketball team.  Against a man-to-man defense, there may be opportunities to drive the lanes and exploit the inside game.  Against a two-three zone defense, there may be opportunities to move the ball on the perimeter and utilize cross-court passes for the outside game.  Against a slower defense, there may be opportunities for long passes and fast breaks for layups.  The point is that no successful team has a single way to win.  They understand the environment in which they're operating and then run the plays that exploit that particular situation.

So it is in trading.  There are times when markets are rotational and relative movement can be exploited.  There are trending periods that call for directional trading.  There are also noisy and quiet periods that lend themselves to edges in volatility space.  A great number of trading opportunities occur when environments change and participants are caught playing the old game rather than changing their offensive alignments.

Great traders, like great sports teams, have multiple ways of winning under varying conditions and circumstances.  When traders lack adaptability and trade limited sources of edge, they find that what worked in one period of time suddenly does not work now.  That leads to frustration, and that can lead to subsequent poor trading.

The problem, however, is *not* primarily one of trading psychology.  The disruption of psychology is the result of the problem, not the primary cause.  It is the limited, inflexible trading edge that makes us vulnerable to changing markets and variable performance.  Expanding what Mike Bellafiore calls our playbooks--our sources of edge in different market conditions--is one of the most powerful ways in which we can fortify our trading mindset.

Further Reading: