Last Updated on 3 November, 2022 by Samuelsson
The financial markets are highly competitive, and amateurs and beginners can easily become prey for the predator higher up the food chain. Thus, having some form of an edge in the markets is crucial to surviving in the market.
A trading edge is a persistent anomaly in the market that can give you an advantage over the other players in that market. It is something that helps you build a complete trading strategy, as it is the basis of any trading system.
In this post, we will explain what a trading edge is and give some examples.
What is a trading edge?
A trading edge is an inefficiency you identify in the market, which, when exploited, can offer you an advantage over the other players in the market. You may define it as the central factor around which you build your trading strategy because it is based on something that shows better returns than the average returns.
You find trading edges by doing your research, reading financial journals, brainstorming, and interacting with other traders. The beauty of trading is that of creativity, so you’re the one to turn the trading idea into an implementable trading strategy. As you can deduce, a trading edge is not the same as a trading strategy.
How does a trading edge differ from a trading signal?
A trading edge is something that deviates from the normal, thereby creating an inefficiency that can be exploited with the right rules and criteria. On the other hand, a trading strategy is a complete system with rules for identifying trade setups and when to exit from the market.
An edge has the potential to become a complete strategy when the criteria for defining when to buy and when to sell are established. Additionally, you need to also consider money and risk management.
Examples of a trading edge
Here are a few examples that can illustrate what trading edges are about:
The end of month edge
The S&P 500 tend to make a slightly better return per day at the end of the month compared to any other period of the month.
Take a look at this simple test in Amibroker:
- The average gain in SPY (S&P 500) from close to close any day of the month is 0.04%, with dividends reinvested.
- However, the average return increases to 0.11% for the days after the 26th of the month — 27th or later.
Since holding the S&P 500 from close to close any day from the 27th calendar day or later yields a return that is more than twice as big as the average gain on any random day, there is a significant difference, which we can call an edge.
See the equity curve of 100 000 invested in SPY in 1993 up until 2020 — the buy order is sent on calendar days 27 or later:
Compare this to the accumulated return by investing only on any random calendar days 26 or lower:
As you can see, investing only on days 1 to 26 shows a huge drawdown and would have been at a loss in 2008.
The end of the month anomaly is not a trading strategy on its own — it’s just an edge that can be used to develop a complete strategy with entry, exit, and risk management.
The mean-reversion edge in stocks
The stock market has been showing strong mean-reverting tendencies for the most of more than two decades. Whenever there’s any sharp fall or rise, it’s usually followed by an opposite movement.
While that is not a trading strategy on its own, it’s an edge that can be developed into a strategy using any of the internal bar strength indicator (IBS), MACD-histogram, or RSI(2) indicators
Note that mean reversion only works for short-term plays — just a few days.
Momentum is another popular trading edge. Research shows that top-performing stocks tend to continue performing in the months that follow, while poorly performing stocks tend to continue performing poorly.
This anomaly (an edge) can be developed into a trading strategy by formulating the criteria for choosing the top performers and determining when to buy them, as well as selling the losers. You also need to consider the timeframes: how many periods to use as the lookback period and how many periods as the holding period.