How to get an edge on the market
If you’ve ever played roulette, you’ll know that it’s a pure gamble.
Without magnets and a complex cheating method – which you’re likely to get caught out over rather than profiting – it’s statistically impossible for you to have a statistical advantage over the house when playing roulette.
Over the long run, the house will win.
It’s down to one number (two on an American wheel).
Those are 0 (and 00 on the US wheel).
This small change in composition adds up to statistical impossibility that over, say, 10,000 spins, the house will lose.
And this is the same in trading.
That little thing called spread is what makes you statistically unlikely to come out as a winner after 10,000 trades…
That is, if you don’t know what your edge is.
Finding your edge
Back in August when I first started writing to you, I had spoken about this.
But I just want to briefly remind you about how to find your edge, as I believe it to be critical when trading.
When you have a specific strategy that you want to test, you do three things…
First, you backtest.
This means going back through your charts looking for where you would enter and exit your trades based on whichever criteria your strategy requires.
This could be trading a breakout from a specific pattern with set stop losses and take profit criteria.
Next, you test this on demo, here is where you find that over 200-500 trades, the strategy roughly works – or doesn’t.
You should at this stage have a relatively good idea as to whether you have something valid or not.
If you don’t, go back to the drawing board and adjust, since you do not want to waste your time.
After that, you run a forward test where you actively trade, but with maybe 1/10th – ¼ of your normal risk.
This is to make sure that it works live… and that your psychology fits.
If that works, you can be pretty certain that your strategy is functional.
This is when you’re ready to run a final forward test at full risk (1-2% risk per trade).
If this comes off, then you have a strategy that is ready to go live.
At each stage, you should want to work out your expectancy.
This is the expectancy equation…
(Reward to Risk ratio x Win Ratio) – Loss Ratio = Expectancy Ratio
If we say that our strategy has an average reward to risk of two, a win rate of 55% (and therefore a loss ratio of 45%), our expectancy ratio would look as follows.
(2*0.55) – 0.45 = 0.65
This means that we look to return 0.65 times for each loss we have.
That is a profitable and therefore a valid strategy.
Know that you have followed the required statistical steps to make the value significant, and that is all you need to have to be confident in trading your strategy.