A trading edge is a technique, observation or approach that creates a cash advantage over other market players. It doesn’t have to be elaborate to fulfill its purpose; anything that adds a few points to the winning side of an equation builds an edge that lasts a lifetime. Don’t be frustrated if you haven’t found one yet because the majority of traders don’t even know it exists. It’s the primary reason why a few book excellent profits while everyone else struggles with weak or negative returns.
There are many ways to build trading edges but we’ll focus on one approach that capitalizes on the technical skills you’ve already learned. It's a simple process that takes an established strategy and adds detailed rules to filter out the majority of potential candidates, focusing your attention squarely on the most promising opportunities. It then introduces a second rule set to your trade management, seeking the biggest profit from each winning position.
A quick reality check will tell you if your trading strategy has a definable edge. List the most common methods you use to find new opportunities, entry and exit positions and manage risk. Then try to remember where you learned those specific concepts, whether from a book, web site or another trader. Finally, consider how many other market participants are playing the exact same strategies, often at the exact same time.
Through this self-reflection, most traders will quickly realize they’ve become lemmings, opening positions and managing risk using the same strategies as the majority of market players. There are two reasons why it’s impossible to book reliable profits when you’re part of this crowd. Firstly, you’re competing with all those people for the same pot of gold. Secondly, crowds attract unwanted attention from other traders who notice the liquidity pool and execute predatory strategies to shake out weak hands.
The sheer number of participants acting in the same way eliminates the edge that made those strategies work in the first place. But that doesn’t mean you need to abandon the trading and technical analysis skills you’ve taken so long to learn and master. In fact, edgeless strategies popularized in books and websites work really well as building blocks for more powerful techniques that will retain their edges through a lifetime.
Markets change all the time, creating and destroying trading edges that tap into the complexities of the current cycle. The trick with these temporal edges is to work them aggressively until the crowd shows up, and then back off, utilizing them only when other folks are leaning the wrong way. "Buy the dips" strategies, which were very popular at the turn of the millennium and after the 2008 crash are classic temporal edges that failed miserably in more challenging market conditions...unless specialized rules are applied.
Regulations and technology also give way to temporal edges, with the rise of high-frequency trading (HFT) as a strong example. Prior generations enjoyed similar edges with bullet trading and Level II scalping. System traders have an advantage over discretionary traders with these highly technical strategies but destroy their edges by over reliance on back-tested results that fail to account for the market’s dynamism.
Creating Your Own Edge
Like edgeless concepts found in books and websites, temporal edges provide a foundation for more powerful strategies. To show how this works, we’ll take the "buy the dips" strategy and apply special rules that identify entry prices where the crowd is unlikely to join us. It’s easy to get shaken out if we enter too early, so our primary task is to identify narrow levels where reversal odds are so great we can utilize tight stops with confidence. Then, if we can replicate results across multiple securities in divergent markets, we’ve overcome the temporal disadvantage and identified a trading edge that may last a lifetime.
We’ll apply the concept of cross-verification to our "buy the dips" scenario, looking for as many technical reasons as possible that our security will turn at a narrow price level. The more cross verification points we uncover, the higher the odds that level will act as intended in stopping a decline and triggering a bounce. We’ll pass on the opportunity if we can’t find at least four cross-verification points. Finally, we’ll apply opportunistic management rules to book the biggest profit, which usually means taking advantage of the crowd after they see the bounce and jump in mindlessly.
iShares Dow Jones US Real Estate Index Fund ETF (IYR) broke out of a three month cup and handle pattern in November, also completing a longer-term breakout. The rally stalled at a 6-year high near 78 and settled into a rectangle pattern above new support. The fund broke down nearly three weeks later, penetrating new support but not breaking it, providing the first verification point for our strategy. The November 21 breakout gap (red circle) filled up, landing price on support at the 50-day EMA, adding second and third cross-verification points. That level also marks the .786 retracement of the breakout swing, adding a fourth point, while Stochastics plunges into the deeply oversold level, marking a fifth clue that a recovery will begin between 75 and 75.50.
Price structure and seasonality raise odds even further for our specialized dip trade. The crowd missing the breakout entered positions within the rectangle, which were subsequently targeted in the breakdown, but we’re executing a strategy that benefits from their pain, providing us with a lower entry price. And since they’re selling while we’re buying, it’s less likely we’ll get targeted by predators. Seasonality comes into play because the breakdown happens during options expiration, dropping the fund into the popular 75 strike, forcing the pool of open interest into worthless positions.
Now we apply our edge to finding a fruitful exit, hopefully using the crowd to our advantage once again. Two potential exit points appear, one at the prior high near 79 and a second at the rising highs trendline near 80. Exiting into the prior high offers the safest route because it’s the location where sellers could trigger another reversal. Our tape reading skills now come into play because price settles into a bullish 60 minute consolidation that lasts for 8 hours (black rectangle on 60 minute chart).
The lack of selling pressure emboldens us to play for the higher exit, which has three advantages. First, it will hit 80, a natural open interest target during expiration. Second, it will push out the top Bollinger Band, setting off a common sell signal. Third, it will reach resistance after a small scale breakout encourages a new crowd to take risk. We ride their greed into the magic number, taking a sizable profit while predators line up to feed on the newly minted bulls.
The Bottom Line
A trading edge defines your technical or strategic advantage in the highly competitive market environment. Traders can establish multiple edges by starting with popular strategies and customizing rules to lower the risk of getting trapped with the emotional crowd.