With proper risk management but no edge, you likely won't beat the market in the end.
What is an “edge” in trading?
A trading edge is a belief that a tactic, technique, observation, or knowledge creates a profitable advantage over other market participants.
This can be both a tangible and intangible notion, and I’ll get into that later.
Do trading edges exist or not?
There can be plenty of debate on the reality of the existence of trading edges. Ultimately, everything may be random, but only time can tell that, and for now, testing can show that actions can be taken to give a person a better chance for success or to “beat the market.”
The concepts of trading edges all stem from the underlying idea that the markets are not efficient. This means that frequently prices DO NOT reflect the true value of an asset. This can be for several reasons, such as information asymmetry (insider knowledge), low liquidity, or emotional market participants (fear/greed). These conditions can cause a misrepresentation of value which can be exploited for profit by those who recognize the inaccuracy.
The opposite side of the coin is that markets ARE efficient, that at all points in time, the markets reflect the true value of assets, and that all public and private information are already priced in. No amount of analysis, fundamental or technical, can be exploited to predict or beat the market.
As a technical analyst, the Efficient Market Hypothesis is a hard pill for me to swallow. There is empirical testing to show that people can consistently outperform the market, and there are techniques that will accurately forecast future events. However, there are many, many market participants, and those who underperform outweigh the overperformers and an argument can be made that those who do outperform are doing so solely out of luck and/or due to the law of probabilities; some people will inherently outperform others, and it is fitting of a standard distribution of results.
It’s quite an interesting concept for further exploration if you so choose to expand your knowledge on it. Even though I don’t fall in line with EMH understanding, it helps to realize the opposite of it as well.
What is a tangible example of a trading edge?
This may include a particular trade setup. For example, I enjoy using price action to confirm and/or trigger an entry for a particular market condition. One such example would be the engulfing candle. Without getting too deep into the technicals, an engulfing candle is when the next candle envelops the trading range of one candle.
This particular candle pattern shows that the sentiment has shifted from the first candle and reversed on the next candle. There could be many reasons for this change in mood, but it is a tangible representation of one side of the market overpowering the other. One could bet that this trend shift may continue in the reversed direction.
Below is a simple backtested strategy in tradingview using this particular trade setup using Bitcoin on the weekly timeframe. Each candle represents one week. The strategy is buying Bitcoin the week following a bullish engulfing candle and selling at the close of the week, the is only open for seven days. This is not an endorsement of the particular strategy or trading advice. I’ve pointed out two stats in the performance report at the bottom.
The white arrow is highlighting the Percentage Profitable calculation. It is showing 57.14%. This means that out of all the possible trades, it was a successful (profitable) trade 12 out of 21 occurrences. While that’s not ideal, it’s still better odds than 50% or randomly guessing 21 weeks to take a long position.