Strategies and Edge

Key takeaways

1. A strategy specifies decisions; a claim of edge requires evidence of a positive expected net result under evaluated conditions.

2. A winning trade or strong-looking stretch cannot establish an advantage. Costs, execution, market conditions, and the path of the trade affect the result.

3. Examine how rules were selected, what assumptions were used, and whether evaluation information remained independent of development.

4. Automation, discipline, and small position size do not prove an edge. Confidence should remain open to revision as evidence changes.

Full transcript

Strategy and edge

You have a trading plan.

You have described the market, the conditions you require, the orders you intend to use, and the reasons to stand aside.

Now comes another question.

Why should those decisions produce a favorable result over repeated attempts?

That question takes us from defining a strategy to investigating whether it has an edge.

A strategy tells you what to do under specified conditions. An edge is a claim about the advantage those decisions may provide.

You can have the first without establishing the second.

For this lesson, we’ll separate those ideas, look at what can make an advantage plausible, and explain why an attractive result still needs to be examined.

We are not selecting a strategy to trade. We are learning how to evaluate the claim.

Define the decisions

Start with the word strategy.

People sometimes use it to mean a chart pattern, an indicator, or a general style of trading.

“I trade breakouts.”

“I use moving averages.”

“I look for reversals.”

Those descriptions identify an area of interest. They do not yet tell you exactly which trades qualify or how the positions are managed.

A breakout approach, for example, still needs to define the level, what counts as a break, the eligible trading window, the entry process, and the exits.

It also needs position sizing and rules for situations where the intended trade cannot be carried out.

The details matter because changing them can change the results.

Two people can describe themselves as breakout traders while making very different decisions.

An indicator can help describe a condition. It does not, by itself, establish that acting on that condition will be profitable.

The strategy is the set of decisions you can actually apply and examine.

Expected does not mean promised

Now consider edge.

For the kind of trading approach we are discussing, an edge means a positive expected net result from applying the approach repeatedly under the conditions being evaluated.

Expected does not mean promised.

It describes an average across possible outcomes, weighted by how likely those outcomes are. Those probabilities are not directly visible on your chart. In practice, they must be estimated, and the estimates can be wrong.

A strategy with an advantage can lose on its next trade. It can experience a sequence of losses. And an approach without an advantage can produce a winning trade or a profitable stretch.

That is why the next outcome cannot settle the question.

One attempt versus repeated opportunities

Think again about a sports team.

A coach might choose a play because it creates a useful opportunity against a particular defense. The play can still fail on that attempt.

Another play might succeed because of an unusual mistake by the opponent. That success alone does not show that it was the better choice.

In trading, we face a similar distinction between the result of one attempt and the quality of the approach across repeated opportunities.

But there is an additional difficulty. The conditions can change. The opportunities you measured may not continue in the same way.

So a claim of edge needs both evidence and boundaries.

Costs change the result

One boundary is cost.

Suppose a hypothetical series contains ten trades.

Six finish with a price gain of one hundred dollars each. Four finish with a price loss of one hundred dollars each.

The gains total six hundred dollars. The losses total four hundred dollars. Before costs, the series is ahead by two hundred dollars.

Now suppose the combined commissions, fees, and additional execution costs total twenty-five dollars per completed trade.

Across ten trades, that is two hundred fifty dollars.

The net result becomes a loss of fifty dollars.

These numbers are invented to explain the relationship. They are not a forecast of trading costs or evidence for a strategy. Execution costs must also be counted consistently, so a difference already included in actual fill prices is not deducted again.

The point is that an attractive price result can disappear after the cost of carrying out the trades.

Winning more often is not enough either. The size of the gains and losses matters alongside their frequency.

We’ll work through those measurements in the next lesson.

Conditions and the trade path

Another boundary is the situation in which the strategy is supposed to work.

A proposed approach might depend on a particular market, a time window, the amount of price movement, or the availability of liquidity.

An observation in one setting does not automatically transfer to a different instrument or a different period.

For example, suppose someone notices that price often moves higher after a particular condition.

That is a starting observation.

To turn it into a trading claim, you need to know when the condition became observable, what entry was possible afterward, what adverse movement occurred, and how the position would have ended.

Price eventually moving higher does not mean every entry along the way would have made money.

The path, the exits, and the execution can change the answer.

Idea, strategy, evidence

It helps to separate three stages.

First, the idea.

What behavior might create an opportunity, and why might it occur?

Second, the defined strategy.

What decisions would attempt to capture that opportunity?

Third, the evidence.

What happened when those decisions were evaluated, and what limitations affect the result?

A reasonable explanation makes an idea worth investigating. It does not establish the advantage on its own.

Strong results need examination

A strong result also does not explain itself.

It could reflect a useful effect. It could reflect chance, a narrow favorable period, unrealistic assumptions, or choices made after the outcomes were already visible.

Suppose you examine many combinations of entry times, indicators, stops, and targets, then show only the most profitable combination.

The result may look impressive partly because you gave yourself many chances to find something impressive.

You need to know how much searching produced the selected result. Otherwise, a lucky selection can be mistaken for a dependable discovery.

Development and independent evaluation

This is one reason to separate the information used to develop an approach from information reserved to evaluate it afterward.

If you keep changing the rules after seeing the evaluation results, that information becomes part of development too. It no longer provides the same independent check.

We’ll examine that process more fully in the lesson on strategy testing.

Backtests and live results

For now, recognize that a backtest is a simulation of decisions using historical information. It is not a record of actual fills.

Its usefulness depends on the data, the rules, the assumptions, and how the test was conducted.

Live results answer some different questions because real orders and actual execution are involved. They still need context, including the period covered, the costs, the exposure, and whether the same rules were followed.

Neither label removes the need to inspect the evidence.

Discretion, automation, and discipline

Discretion and automation do not settle the question either.

A discretionary trader uses judgment in applying an approach. That judgment needs to be described and recorded well enough to understand what actually happened.

An automated system applies programmed instructions. Those instructions can be precise and still have no advantage. Software can also contain mistakes or behave differently from the intended rules.

Automation changes how decisions are carried out. It does not establish that the decisions deserve to be carried out.

The same is true of discipline.

Following a defined process makes its results easier to interpret. But following an unprofitable approach more consistently does not give it an edge.

Risk management matters because it shapes exposure and the outcomes you can experience. Small position size alone cannot establish that the underlying strategy has a positive expected result.

You need to examine both the approach and the consequences of applying it.

Questions to ask about an edge

So when someone says a strategy has an edge, slow the claim down.

Which strategy, with which exact rules?

In which market and conditions?

Based on what evidence?

After which costs and execution assumptions?

How were the rules selected, and what happened when they were applied to information that had not been used to choose them?

And what remains uncertain?

You do not need to reject every trading idea. You need a way to distinguish an interesting possibility from a conclusion that the evidence can support.

Confidence remains open to revision

Confidence can grow as an approach survives meaningful evaluation. It should remain open to revision when new evidence changes the picture.

A strategy describes the decisions. Evidence helps you judge whether those decisions may offer an advantage, under what conditions, and with what limitations.

In the next lesson, we’ll make the results easier to read by connecting win rate, the size of gains and losses, expectancy, and drawdown.

Those measurements will help us ask a better question than simply, “How often does it win?”

Win Rate, Payoff, Expectancy and Drawdown

Connect how often trades win with the size of gains and losses, average results, and declines from a peak.

Lesson 9 is available now.