Finding edge in the financial markets
What is edge? How to find it?
Step 1: Definition of what is a market?
If we want to boil down markets to a simple concept, we can say that a market is where two participants, a buyer and a seller, come together to find agreement on the price of a good or service.
If the buyer agrees to pay the value that the seller is asking for a certain good or service, then a transaction is made.
In the financial markets, with all the technology we have today, this process is done at an extremely high speed, which often leads traders to not think about the fundamental concept of financial markets, which is, that they are like any other market. Just at a must faster pace.
If you are going to be a buyer, your goal is to buy something that is worth X at current time, and sell later for a price above the X you paid for it.
If you are going to be a seller, your goal is to sell something that is worth X at current time, that is currently valued higher than the X you paid for it.
In order to do this you must have an edge over all the other millions of market participants. What is an edge?
Step 2: What is an edge?
An edge in a market is your advantage to the competition. If you are competing against other players in the same game, you need an advantage to win. This advantage is an edge.
Let’s look at this simple example:
There’s a store in a local market that sells cakes. That store has 5 other stores in the same small town that sell the same cake. All of them are competing for the same share of the market. How can this store beat the competition and provide the best business of all cake stores in that town?
Let’s say that the store’s owner has an uncle that provides him with a selection of high quality ingredients at a much lower market rate. This store owner can now provide the same cake, at much lower cost with higher quality of ingredients. Over time, who do you think that the market will choose?
The higher cost, lower quality cakes?
The lower cost, higher quality cakes?
That is an edge. A very specific edge that can be used to stay in business and be the best competitor in that small town. Does it mean that the other competitors must close their business? Not necessarily, they’ll just have lesser clients and smaller margins.
Step 3: How to find edge in the financial markets?
Trading the financial markets is a much more complex business than the cake store for that small town.
We are dealing with high frequency trading bots, extremely advanced mathematical models, hedge funds with billions of dollars invested in R&D, top quality individuals, etc.
The competition is extreme and it makes it hard for retail traders to get ahead when competing against this odds.
Yet year over year we see small traders from all over the world produce consistent returns and even beating the market. How is that possible with such competition. How do they find their edge?
1- Competition against hedge funds
You as a retail trader have the advantage of flexibility. You don’t have to abide by extreme regulations of managing other people’s funds. You don’t have the burden of having to execute billions of dollars and have an impact on the market that can potentially destroy any strategy if not careful. As a retail trader you can go into markets where liquidity might not be as good for a hedge fund, but it is perfect for you and have an edge over lesser qualified traders than you.
The point is that you have the flexibility of choosing which markets to trade, when to trade and how to execute, without having to need extremely complex infrastructure.
2- Competition against other traders
Retail traders are often irrational and that translates into opportunities that a careful trader with some knowledge can exploit. For example traders that are buying a 4hour 50% increase in price. What are they asking when they do that? Prices will stop going up due to lack of demand and an increasing supply due to short-sellers thinking is too high and buyers having a very decent gain. Those traders that are buying at those sharp and fast increases are going to be left out holding those bags and will want to get out of their positions at lower prices.
This is a way that you can start thinking strategically about edge. Put yourself in the shoes of your competition and try to understand what guides their movements. Usually greed and fear are the main drivers for people.
After you have a general thesis about how you can participate profitably in the market, you can start testing it with data. If you have an hypothesis, and it can be observed, most likely you can see that in data somehow. At the simplest level, get every possible trade on paper and understand what are the outcomes. You need to have a statistical edge. Just because you think something is logical, it doesn’t mean that the market agrees with you. Try to be systematic about the process.
This is how you find edge.