Last Updated on 17 November, 2020 by Samuelsson
Learning what a trading edge is, and how to develop one is the most important thing you will learn in trading. Despite this being the case, most traders do not even know what a trading edge is, let alone how to develop one.
To develop a trading edge, you need to come up with an idea that works in the markets. You can find ideas on trading forums, in trading articles or here at The Robust Trader. Last but not least, you need to backtest your idea to ensure that it actually works.
So how do you actually go about developing a trading edge? Read on, and we will show you how!
What Is a Trading Edge?
A trading edge is recurrent market behavior that is not the result of random chance, our luck. By defining this behavior we can say that we have a trading edge.
To give an example, our trading edge could be that we have noticed the market’s tendency to rise the day after two consecutive lower closes. Having this type of knowledge is what separates gamblers from traders. With a trading edge, you are not acting on a whim or random chance like most beginning traders, but on solid evidence.
Still, the process of developing a trading edge has many pitfalls, of which curve fitting is the most dangerous of them all. In our article on curve fitting, we explore what curve fitting is, and how you can avoid it.
Do not miss our unique trading edge library. The heart of the Robust Trader. New edges every months.
Defining a Trading Edge
Before going further we need to define what we mean by a trading edge. There is a lot of confusion between trading edges and trading strategies, and there really is no clear answer as to how to completely separate the two, since they tend to be tightly knit to each other.
From now on, our definition of a trading edge for this article will be: “a verified tendency in the market, albeit not yet tradable”. That means that the trading edge becomes the first step in creating a trading strategy.
How to Develop a Trading Edge
If you were to define the process of finding a trading edge, it would look something like this:
- Find or come up with an idea.
- Test the idea – Backtesting
- Find out if it holds or not- Robustness Testing
Find or Come Up with an Idea
While experienced traders find this part to be the easiest, beginning traders often wonder how they ever will be able to hatch idea after idea for many years to come. They often make the mistake of rating their ideas, that is being biased, already before they have tested it. For example, they might disregard an idea because it challenges everything they have read online or in trading books. In fact, experienced traders know that these ideas are the most valuable ones, and embrace them fully. In general, the methods that remain hidden from the large masses tend to work best.
However, that does not mean that you cannot find ideas for trading edges in books or online. Every trading related site you read is likely to spark new ideas for you to test, which may be very different from the ones that you read about. In other words, try to expose yourself to trading related material, and you will soon have an endless list of ideas to test.
In our post on trading forums, we have collected the top 20 trading forums where you can find inspiration and ideas for your trading.
**Don’t miss out: How to Start Swing Trading
Test the idea – Backtesting
Backtesting means that you use trading software to simulate how you would have fared if you had taken all trades that your trading edge told you to.
Now that you have your idea for a trading edge, you will have to test the idea. The best way of doing that is to use some form of backtesting software, like Tradestation or Amibroker where you just code your trading edge and let the software present you with information on how your idea has worked historically.
**Don’t miss out: My Thoughts On Amibroker
When performing backtesting, you will see that a majority of the ideas you thought were going to work, just fall apart. Do not give up as this realization dawns on you. Continue testing, and with time you will find a trading edge.
For traders who do not wish to learn how to code, there are non-code alternatives. However, we recommend that you learn how to code yourself since it will provide much greater flexibility.
Find Out If it Holds or Not – Robustness Testing
This step actually belongs more to the strategy creation process since correct robustness testing will make the trading edge ready to trade. However, we find it better to include than exclude such an important topic.
The next step is to take the idea you have found, and test it for robustness. You could say that there are two methods you could use for this.
1) Forward Testing
Forward testing means that you simply observe how your edge holds up going forward. If you have no trading software, you may paper trade your trading edge and log the results. However, this is a very time-consuming technique, that requires you to look trade by trade to determine the validity of your trading edge.
Backtesting, one the other hand is much quicker, but as we have gone into before, it has one serious drawback in the form of curve fitting. Still, backtesting is a great tool to use to determine the robustness in parameter ranges and see how well the edge copes with parameter changes. Generally, you want the trading edge to work with as many settings as possible for it to be robust.
In the end, the best way of validating a trading edge is to use a combination of the two.
A Practical Example of Finding a Trading Edge
Let’s try to find a trading edge.
The first step as outlined above is to formulate the idea. Our trading edge idea will be to buy once the market has made two lower closes, and sell on the first up day. The code for TradeStation would look like this:
If close<open and close<open then buy next bar open;
if close>open then sell next bar open;
I insert the above code into Tradestation and get the following graph in the S&P-500 futures contract.
As you see, it did not work very well, but also did not fall apart completely.
From here you made discard the idea right away, or try to add some filters. Just be aware that the risk of curve fitting grows as you add more filters and conditions. The best trading edges not seldom are the simplest ones.
Struggling to find trading edges? In our growing edge library, we have trading edges for a range of different markets.