For those building a system I can only commend you for taking on such a challenging and potentially rewarding task. It must be said that it is not for everyone as the skills and focus required for developing an edge are somewhat specialised and niche. The 4000 plus hours I invested into SPA3 has taught me this and I have a Maths and Computer Science background which made the task somewhat more achievable. Furthermore, this is what I do and hence have time, focus and resources around me to enable the completion and ongoing maintenance of an edge. I say this as the majority of people who make a decision to develop a system never actually complete it and hence never really get to trade it.

For those interested in buying an edge the equation below may seem less important. But you should have the knowledge to be able to assess any business in the financial services space that may provide advice to you (newsletter, broker, tipster, investment manager,systems provider etc) by asking the question “what is your edge”?

They should be able to prove to you that they have x amount of winners and y amount of losers and that the winning trades are z larger than the losing trades, over a large sample of trades, regardless of what analysis approach they use. At the very least, if a company cannot do this then you should seriously consider not investing money in their strategy or approach. There are other metrics that should be sought but we’ll leave that for another time.

Now that you have a better appreciation from past postings that an edge is needed, the next step is to understand exactly when an edge is good enough to trade profitably and also when there is no edge (i.e. a losing approach).

The first thing we need to know is at what point an edge becomes positive i.e. the minimum threshold.

This break-even point is a Mathematical Expectation (ME) of 0. Outcomes less than 0 lose money and greater than 0 make money.

Let’s use a coin toss example to illustrate what we mean by a break-even edge. If, for whatever reason, over a large sample of coin tosses, we only win 20% of the tosses we would need to win $4, on average, with our winning tosses if we lost $1, on average, for every losing toss, just to breakeven. Mathematically:

We call the 20% in the above example the Win Rate. We call the average dollar win divided by the average dollar loss the Profit Ratio, i.e. 4/1 = 4 is the Profit Ratio.

Using this formula, the Profit Ratio required to achieve a breakeven threshold for a given Winning Rate can be calculated as follows:

where WR = Winning Rate and PR = Profit Ratio.

In the above example where the Win Rate is 20% the Profit Ratio to breakeven, as we now know, would need to be:

For example, if 34% of closed trades are winners, what Profit Ratio is required to reach breakeven?

This means that the 34% of winning trades would, on average, need to be 1.94 x larger than the losing trades, after trading costs, to break even. A Profit Ratio greater than 1.94 would mean, over time, that your closed trades would be showing a net profit.

So depending how often a trading approach wins, the Profit Ratio defines how much bigger the net profit for winning trades, on average, must be than the net loss for losing trades, on average, so that you breakeven or better.

Any edge that is better than breakeven will make money over time provided that sensible money management is used. For example, if all capital is placed on single trades this could lead to disaster over a small sample of trades.

The Breakeven Table below shows, for a given Win Rate, how much a winning trade, on average, needs to return for an average loss of 1 unit.

A trading edge is a set of entry and exit criteria that, when executed, will deliver profit trades that are sufficiently large enough to cover your trading costs and loss trades, and deliver you a positive return on your capital and time. The biggest strength of deploying an edge in the market is not the edge itself, it is the processes that define executing the edge. These processes will keep you engaged in the game. Focus on your processes and the outcomes will take care of themselves. Change your focus to the outcomes and your processes will break down which will lead to worse outcomes than you otherwise would have had. Breakdown of process leads you off on dead-end tangents and trial and error on the fly. This should be done during the preparation (research) phase, not during execution.

Most technical analysts are on a quest to find the ‘best’ edge. Just as a carpenter sees all things in terms of a hammer and nails, an analyst’s paradigm is that of analysing technical entries and exits. Most analysts spend so much time searching for the ‘perfect’ entry technique that they never actually get around to trading. They are wonderful at telling you what they would have or should have done, but unfortunately this is usually with the clear vision offered by hindsight!

The trader’s paradigm is that of executing trades according to their edge. The trader’s aim is NOT to find the BEST edge – it is to discover an edge that is positive and outperforms their chosen market / benchmark over the long term. They then deploy this edge to allow them to confidently engage the markets by risking capital to make profits – a trader trades, an analyst analyses. Analysis is just one of the techniques required to be a trader, it is a small part of the overall trading formula. Profitable traders realise that consistently applying their trading ‘edge’ to the markets with trust and confidence and employing strict money management and risk management rules is the key to long term success. At the end of the day, trading is a doing word – to make money we have to trade. We don’t make profit trades sitting on the sidelines trying to discover the perfect entry system. We make money by taking trades – cutting the losers and maximising the profit potential of the winners, in your chosen timeframe for trading.

The BEST edge will NEVER be found. Take my word for it because the BEST edge is perfection, 100% winners, which does not and never will exist in any game, let alone trading, (unless you do 1 trade, win and never trade again – but this defeats the object of risking capital to make profits unless you bet the house and ….. tempting!?). There will always be a better edge than the one you are using, either existing and in use somewhere on the planet or yet to be discovered. You will always be further ahead in the long haul by engaging the game according to a set of researched rules than being out of the game searching for the ‘best edge’ or being a spectator.

The fact is that well below perfection is OK to make money, and lots of it. Simple arithmetic proves this to us. Execution of that arithmetic has proved this to me personally and many of our customers over many years now. It is the understanding of what it means not to have to be right and hence what an edge is. An edge is probabilistic, by definition. Having 41.18% winners where the average winner is 2.68 x larger than the average loser net of brokerage and slippage, doing 6.85 trades a month over 6.06 years has delivered an annual compounded return of 24.2% compared to the ALL-ORDS of 10.2% and to the ALL-ORDS Accumulation Index of 14.4% over the same period. This information is updated regularly on our website at http://www.sharefinder.com.au/SPA3%20performance.php.

Opportunity cost through being a spectator from waiting to find a better edge or fearing using an existing proven edge will invariably be larger than the profit from the compounding of profits offered by time spent in the market using a proven edge. Lost opportunity leads to feelings of anger and frustration and causes silly mistakes to be made by those trying to make up for lost opportunity. The spectator will always be behind on the learning curve compared to the player. However, “look before you leap.”

My message is: find, through your own research & development and/or otherwise, a credible proven edge, engage the game and get on with honing the remaining execution skills required to be consistently successful before time has passed you by and you have missed the opportunity of achieving compounding profits.

Traders employing a discretionary or subjective bias to their decision making can suffer enormous swings in their emotions – from euphoria when they get a winning trade, to dread and horror when they lose. Anyone hoping to achieve longevity and long term success in the markets can not trade in this way. It is simply not sustainable over the long term, because there is no plan in which to trust.

The dictionary defines trust as “reliance on the integrity, strength, ability, surety, etc., of a person or thing; confidence”. Many actions we trust inherently because the results are well within the emotional bounds between life and death. Take every day driving of a motor car. Every time that we drive a car there is a chance that we could get killed in an accident. There is nearly one motor car fatality every day, on average, in each state in Australia. However we don’t get behind the steering wheel and fear our impending journey. Why not? Two reasons. Firstly, we trust our driving skill and, secondly, we inherently know and trust that the probability of a fatality is extremely low. That is, we trust in the probabilities of getting to our destination alive. The roads are a probabilistic environment.

Other actions, including execution in the market, require that trust is earned, both in our own skill and in the probabilities that exist in executing in the market. The market is a probabilistic environment.

Much of the trust for executing in the market will come from having a well developed and researched process that you know produces a positive outcome over the long term across a wide range of market conditions. The research and development is your preparation as discussed in last week’s blog. The output is a trading system that is part of a trading plan that defines the process. The trading system must have an edge. The edge is defined in terms of probabilities and it is these very probabilities in which you trust. There is no certainty in any trade yet there is certainty over a large sample of trades because the probabilities of the edge will be met.

To find a trading system that has an edge you must make a decision; you either spend considerable time gaining the knowledge and conducting the research to build an edge, or seek out an existing and proven edge to buy. Build or buy?

Most people who choose to build never complete their edge, or at least to the point that they trust it, and hence never get to the point of executing with a predefined edge in the market. Building is only suitable for a very small percentage of investors who have the necessary skills, time and mindset. It is tough work building an edge but for those who do, it is very rewarding.

Buying an edge involves a leap of faith. To take that leap of faith there is some fundamental information that should be sort. You need to assess the builder’s qualifications, experience and ethics, and ensure their researched edge is transparent and works. The ultimate proof is the equity curve over the long term through multiple market ups and downs. It is not the result of each trade that matters, or even a few months trading – it is the overall result of the edge over multiple market conditions over a large sample of trades, including brokerage and slippage. This level of proof goes well beyond the much maligned black box systems that are regularly sold to the unwary. Trust is “reliance on the integrity and qualities / attributes” of the edge.

By choosing to buy an edge, your time can now be spent developing other areas that build trust and allow you to execute with confidence. This includes developing your trading plan, learning the processes of your trading system, improving execution and developing your trading mindset. By sticking to the rules of the trading plan, you are able to execute the trades as and when they come along with no emotional attachment to the outcome of each trade. That’s trust!

Trading is an endurance activity not a sprint. In order to survive over the long term we must have a process and set of rules we can trust. It is the probabilities of the system over the long term that we need to understand and trust.

My friend the bike rider who featured in last week’s blog, trusts his bike 100%. He prepared first and trust followed. He chose to employ, buy, a mechanic with the desired qualifications and proven experience to build a bike he can trust. As a result, my friend is able to focus on the planning and execution, pushing himself to the limits of endurance because he has the confidence to do so. This trust gives him an edge over other riders who may not have developed the same level of trust with their bike, and even with their own mind and body. Those that lack this level of trust and thus confidence, are not able to perform as well under pressure or after more than 20 hours of gruelling physical and mental endurance.

Preparation….. trust…….confidence…….execution.

Trading the markets is the same. We need to have trust – in the edge of our system, the development and workings of the system, and most importantly, ourselves. There is no other high probability way of doing it. Preparation will develop trust which will develop confidence which will overcome the emotional turmoil of fear, uncertainty, doubt and trepidation that the markets would otherwise deliver.

I have learnt that you cannot trust and fear (or worry) at the same time. So which of the two will it be for you when it comes to the market?