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Trading with an Edge

In order to get positive return in the long run, we need to have positive expectancy in our trading system. In trading, the best edges come from the market behaviors caused by cognitive biases. To find an edge, you need to locate entry points where there is a greater than normal probability that the market will move in a particular direction within your desired time frame. You then pair those entries with an exit strategy designed to profit from the type of moves for which the entry is designed. Simply put, to maximize your edge, entry strategies should be paired with exit strategies.

To understand why this is important, let’s dig further into the components that make up the edge for a system. System edges come from three components:

  • Portfolio selection: The algorithms that select which markets are valid for trading on any specific day
  • Entry signals: The algorithms that determine when to buy or sell to enter a trade
  • Exit signals: The algorithms that determine when to buy or sell to exit a trade
It is possible for an entry signal to have an edge that is significant for the short term but not for the medium term or long term. Conversely, it is possible to have an exit signal that has an edge for longterm systems but not for the short term. Some concrete examples will help demonstrate this effect.

Support & Resistance
Beware of anchoring effect when you look at support and resistance. When support or resistance are broken, the prices may move swiftly in the direction. That is called breakout (can be up or down). So, prices near support or resistance are not stable and unclear. But for one things, prices are certain to change and opportunity emerge for trading to occur. However, one cannot wait too long to see the winning side emerge because it may be too late to enter. So, once decided, bet on one side and set a stop loss on another side.
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