Where Does Edge Come From?
Ships navigating open water have to tread carefully and watch out for icebergs. What makes icebergs so dangerous is they hide up to 90% of their mass below the surface, threatening to tear the hull of a ship. Successful traders have similar features to that of an iceberg - the charts they post only show 10% of what goes on behind every trade. The other 90% involves technical analysis, fundamental analysis, statistical analyses, custom indicators, and backtesting. Oh and let’s not forget, an ocean of coffee to get through all of that work. All of these things come together to give a trader their edge.
With the advancement of technology, proprietary trading software, and advanced algorithms, the odds are even more stacked against the retail trader in this day and age. Just seeing the chart and playing a trade off support/resistance is no longer enough to get the job done. Remember, if everyone can see those lines, what edge do you have in playing them? In order to keep up in this endlessly evolving market, a retail trader needs to do everything they can to swing the odds in their favor. When I look to take a trade, I make a mental list of the number of reasons of why I like that trade. Ideally, I strive to find 5-10 reasons for liking a trade before I take that trade, never just one reason alone. Each of these mental bullet points adds edge for increasing the probability of a successful trade. Similarly, I also make a mental list of the reasons why I don’t like that particular trade. The comparison of these two lists will help me decide whether I take that entry or not. If the two lists have equal amounts of bullet points or there are more reasons for not liking the trade, I will probably not take that trade.
Where do I look to find reasons for making my mental pros vs. cons list?
Technical Analysis - there is so much more then just support and resistance when analyzing a chart. What does the volume profile show? Who is underwater, where are they underwater, and how many are underwater? Where are the critical Fibonacci retracement/extension lines? What wave are we playing in an Elliott Wave cycle? What type of volume and demand is being printed on the chart? What do the higher timeframes show and do they line up with the lower timeframes?
Fundamental Analysis - looking at the filings and background behind a company. What do the critical fundamental factors illustrate about this company? What kind of cash flow does this company have? How does this company raise money when they are pressed to do so? Can this company sell shares through one method or another to produce overhead resistance on a chart?
Market Psychology - understanding the other players who are at the poker table. What side of the trade are most people looking to be on? Are larger players such as institutions or insiders looking to sit at the table? Where are market makers looking to make money by shaking out longs/shorts?
Statistical Analyses - tracking previous tickers that have shown this particular setup. What do the spreadsheets and statistics say about this particular setup? What are recurring qualities of this particular play (i.e. topping time, peak volume, secondary breakouts, flash crashes, etc.)? Does the current trade plan incorporate some of these expected outcomes?
Custom Indicators - everyone uses the same indicators on their charts (i.e. 9 ema, 50 ema, 200 sma, VWAP, etc.). Once again the question must be asked, if everyone sees it what edge do you have using it? Trading firms develop their own proprietary indicators, so if retail traders are to keep up with the big boys, they have to play on the same level. From the statistical data gathered for various setups, one can create custom indicators. Personally, I use custom indicators for volume forecasting (to compare current volume vs. anticipated volume), custom pivot levels, calculated projected topping targets, calculated anticipated profit targets.
Backtesting - developing a new trade idea involves more then just looking at previous charts. After gathering statistical data, one has to rerun those trades based on the trigger entries, calculate expected profit targets and win percentages. Is this new idea profitable? What type of sizing does one need to use for this setup? Where should you expect to take profits?
As mentioned above, a chart with entries and exits only shows how the trade was executed. But the reasoning and preparation for that trade accounts for nearly 90% of what’s happening behind the scenes. This profession is changing every single day and is becoming increasingly more difficult. The trading tactics of the 1990’s and the early 2000s no longer work just by themselves. In order to keep up with big money and big trading firms, you have to play on their level. That means looking at multiple aspects of trading to gather as many reasons for taking that trade. The more reasons to have for taking a trade, the higher the edge for that trade. Don’t limit yourself to just one aspect of trading, consider them all.