What is an EDGE in trading?

[AussieMatt]

So the above is what an edge can be.

How about in trading it is the practical application of a theory that over-time increases an account equity.

I think this is the most useful definition. I would add that both the application and the theory/belief must match the traders personality/philosophy and applied each time to be a CONSISTENT edge. EG I believe when XYZ occurs there is a high probability price will get to ABC (theory), I HATE loosing money/drawdowns (personality/philosophy) so I take small losses/BE trades (application) that then go on to work out before getting my winning trades.

If I ignore my personality when applying my -edge- then I lose that edge over time even if my -theory- has a high win rate.

The CONSISTENT PRACTICAL application of a proven THEORY.

 

[DeepState]

I think this is the most useful definition. I would add that both the application and the theory/belief must match the traders personality/philosophy and applied each time to be a CONSISTENT edge. EG I believe when XYZ occurs there is a high probability price will get to ABC (theory), I HATE loosing money/drawdowns (personality/philosophy) so I take small losses/BE trades (application) that then go on to work out before getting my winning trades.

If I ignore my personality when applying my -edge- then I lose that edge over time even if my -theory- has a high win rate.

The CONSISTENT PRACTICAL application of a proven THEORY.

Interesting that you have inserted the need for a proven theory into this. Whilst I like a combination of theory matching with practice/outcome to proceed, I wonder if theory is actually necessary. I don't think it is, actually.

For example, the options market existed and functioned well before the Black-Scholes-Merton model was developed and applied. They found prices weren't too out of whack with model predictions. Options theory is not something you just conjour up in your head. Yet the market figured it out in the absence of a theory. I figure that there would have been people in that market who understood pricing better than average by instinct or experience and done very well....without knowing what the theory actually was.

Most of the great theories were developed after observation took place, often by accident (Newton's apple, penicillin...). Theory just tried to explain it (backward induction). When theories are developed about how things should be (forward induction), they have a much poorer track record...particularly in adaptive, highly integrated settings...like the market.

Whilst a theory which I can understand and plays out empirically is important for me, personally, I actually don't think it is necessary for an edge to be developed. The cave man who discovered fire had no idea what it was and all of its properties...but used it to advantage anyway.

 

[Wysiwyg]

The CONSISTENT PRACTICAL application of a proven THEORY.

After reading RY's post I thought about use of the word theory in a trading context. I rationalised that there are no facts to any trading outcome unless one has access to information unknown to the public. In other words an outcome shall not be known in advance unless one has access to security related information which is unknown to the public.

That is why, that I know of, there are no 100% winning traders. Not quite like fire!

 

[DeepState]

After reading RY's post I thought about use of the word theory in a trading context. I rationalised that there are no facts to any trading outcome unless one has access to information unknown to the public. In other words an outcome shall not be known in advance unless one has access to security related information which is unknown to the public.

That is why, that I know of, there are no 100% winning traders. Not quite like fire!

I'll bet that cave man burned his butt whilst trying to figure out the properties of fire .

What if the fact was a probability statement? For example, there is an almost permanent imbalance in deep out of the money put options which trade expensive. If you sold them, on average, you will make money. Each individual option that you sell has a payoff which is not known. Yet there is an edge and no inside information is required. It is an edge created through strong risk aversion on the part of some market participants and hedging difficulties in fast moving markets which cause an inventory imbalance within market makers. Your hit rate would actually be very high, but your losses will be huge relative to your gains in a reward to risk sense. In aggregate, you have a positive expectancy.

To use those casino analogies, it's the edge the Roulette dealer gets when the payout is not truly fair. Each spin produces an unknown outcome, but the probability of profit is positive. ...and people play knowing these odds. Though I realise this is not a trading environment, I hope the analogy serves as an illustration. In Roulette, the theory is absolute...but the outcome is unknown. Yet an edge clearly exists.

 

[So_Cynical]

To use those casino analogies, it's the edge the Roulette dealer gets when the payout is not truly fair.

It is what it is, an advantage is an advantage so betting against it is an exercise based in stupidity, while it can win it probably wont so its crazy to bet against it...and that's why i don't punt in casinos any more, still its all a learning experience.

 

[AussieMatt]

Interesting that you have inserted the need for a proven theory into this. Whilst I like a combination of theory matching with practice/outcome to proceed, I wonder if theory is actually necessary. I don't think it is, actually.

For example, the options market existed and functioned well before the Black-Scholes-Merton model was developed and applied. They found prices weren't too out of whack with model predictions. Options theory is not something you just conjour up in your head. Yet the market figured it out in the absence of a theory. I figure that there would have been people in that market who understood pricing better than average by instinct or experience and done very well....without knowing what the theory actually was.

Most of the great theories were developed after observation took place, often by accident (Newton's apple, penicillin...). Theory just tried to explain it (backward induction). When theories are developed about how things should be (forward induction), they have a much poorer track record...particularly in adaptive, highly integrated settings...like the market.

Whilst a theory which I can understand and plays out empirically is important for me, personally, I actually don't think it is necessary for an edge to be developed. The cave man who discovered fire had no idea what it was and all of its properties...but used it to advantage anyway.

Hey RY,

I took theory to mean the traders own personal theory as to why price will do what it will do, not necessarily academic theory. I actually think people over complicate trading far too much and that's the reason a lot struggle they refuse to keep it simple. Your last quote sums my thoughts exactly, you don't need to know a lot about a market to trade it just how to trade it profitably

 

[DeepState]

Hey RY,

I took theory to mean the traders own personal theory as to why price will do what it will do, not necessarily academic theory. I actually think people over complicate trading far too much and that's the reason a lot struggle they refuse to keep it simple. Your last quote sums my thoughts exactly, you don't need to know a lot about a market to trade it just how to trade it profitably

Yeah. I like your perspective very much. Personal theory is another term for 'meme' or 'ideology'. We all have them, shaped from whatever, including book theory and personal experience and we use them and adjust them with feedback (ie. learn from experience).

My personal viewpoint on this is that the market is a contest of beliefs and temperament. Temperament is the ability to stay true to your beliefs under stress. The contest of beliefs, then, can be viewed as if it were an evolutionary contest. As the weakest gazelle tends to be eaten by the fastest lion, the weakest meme (even if loaded full of books and teachings form Nobel Laureates) has the least grip on reality and tends to get smashed by the guys with a strong understanding of how the world actually works. At each contest, everybody learns a bit, new lions and gazelles get born who are generally sired from the most successful of their species (they don't have birth control), others perish from old age or retire young , droughts and rainfalls arrive and go etc. and, thus, the game keeps changing all the time. Never dull.

So an edge is held by any person whose meme/ideology is better adapted to the current circumstances than most. But they can never truly know that it is and, even if it is, it will be unlikely that it will stay so indefinitely.

Finally, we watched a DVD of The Matrix (1999) last night, mostly because I really like the scene where Neo and Trinity lay waste to an office lobby trying to rescue Morpheus. Although generally regarded as marginally less authoritative as a source of education for investing/trading than, say, Fama and French (1993), it helps bring in the behavioural element:

+ Morpheus: What is real? How do you define 'real'?

Because you never really know what is real and are shrouded in uncertainty all the time, our behaviour is sometimes quite at odds with our own beliefs. When you put that into a crowd setting where everyone affects heaps of people, you get even more mushing about and weird stuff happening.

I'll sign off with a quote from an instructional documentary called Men in Black (1997):

+ Agent K: A person is smart. People are dumb, panicky, dangerous animals and you know it!


Some relevant reading on implementing ideas in the event your meme has an edge:

http://www.oaktreecapital.com/MemoTree/Dare to Be Great II.pdf

 

[DeepState]

It is what it is, an advantage is an advantage so betting against it is an exercise based in stupidity, while it can win it probably wont so its crazy to bet against it...and that's why i don't punt in casinos any more, still its all a learning experience.

I still go to casinos.....but just to eat at the buffets which are so cheap because they are subsidised by the gamblers betting with negative odds (except the smart ones on BlackJack). I regard this as buffet arbitrage.

 

[luutzu]

Yeah. I like your perspective very much. Personal theory is another term for 'meme' or 'ideology'. We all have them, shaped from whatever, including book theory and personal experience and we use them and adjust them with feedback (ie. learn from experience).
....

So an edge is held by any person whose meme/ideology is better adapted to the current circumstances than most. But they can never truly know that it is and, even if it is, it will be unlikely that it will stay so indefinitely.

Don't you mean an edge is when their theory/understanding - meme/ideology - ALLOWS them to adapt, not "better adapted", to the circumstances?

In allowing people to adapt, it could mean they do not have to be involved in the current situation, they could just avoid situations that does not suit them - and so benefit by not getting into situation they don't understand.

In saying their ideas better suits the situation, then that's just obvious and it's saying it's more about luck then about their understanding and adaptability.

If not, then it's not much of a structure if it simply adapts and be with whatever situation the current environment is. But then, how could a person with certain ideology not seriously know what those are.

As Bruce Lee said, "be like water, my friend." [i think he took it from Sun Tzu but who doesn't].... And like water, even though it adapts to its surrounding, still retain, still know its nature, its ideology.

Anyway, thought i respond because a slow gazelle is any lion's meat, not just the fastest lion

 

[DeepState]

Don't you mean an edge is when their theory/understanding - meme/ideology - ALLOWS them to adapt, not "better adapted", to the circumstances?

In allowing people to adapt, it could mean they do not have to be involved in the current situation, they could just avoid situations that does not suit them - and so benefit by not getting into situation they don't understand.

In saying their ideas better suits the situation, then that's just obvious and it's saying it's more about luck then about their understanding and adaptability.

If not, then it's not much of a structure if it simply adapts and be with whatever situation the current environment is. But then, how could a person with certain ideology not seriously know what those are.

As Bruce Lee said, "be like water, my friend." [i think he took it from Sun Tzu but who doesn't].... And like water, even though it adapts to its surrounding, still retain, still know its nature, its ideology.

Anyway, thought i respond because a slow gazelle is any lion's meat, not just the fastest lion

Read Charles Darwin (Origin of the Species). Then read Andrew Lo (Adaptive Markets Hypothesis). Then, if you have time on your hands, read about genetic algos in relation to artificial intelligence and optimisation. And finally, take a look around you and see how things are.

The framework which has been proposed is misaligned, in my view.

 

[luutzu]

Read Charles Darwin (Origin of the Species). Then read Andrew Lo (Adaptive Markets Hypothesis). Then, if you have time on your hands, read about genetic algos in relation to artificial intelligence and optimisation. And finally, take a look around you and see how things are.

The framework which has been proposed is misaligned, in my view.

I was assigned "On the Origin of Species" - the professor said it's one of the best books ever written - still on the shelf, unread. Also did an entire course on Artificial Intelligence/Cognitive psychology... and for the life of me, don't remember what was taught there. So that's me as a student

Still, I don't think you could apply these principles of adaptive behaviour to the market. Or even contrarian behaviours and the likes.

I stick to the principle of: No matter how loud the wind howl, the mountain will never bend to it (Chinese Emperor, Disney's Mulan). True that the grass that bend with the wind will never break (Confucius?), and probably sleeps better, and get to keep his job too, but I don't think adapting to the market and the general public opinions, or merely be contrarian to it, is what adaptation for survival ought to be, not in the stock market.

You can't outperform the market if you think and adapt and act like them... you just have to do what you think is right, and if the market think the same, cool.. .else...

 

[DeepState]

I was assigned "On the Origin of Species" - the professor said it's one of the best books ever written - still on the shelf, unread. Also did an entire course on Artificial Intelligence/Cognitive psychology... and for the life of me, don't remember what was taught there. So that's me as a student

Still, I don't think you could apply these principles of adaptive behaviour to the market. Or even contrarian behaviours and the likes.

I stick to the principle of: No matter how loud the wind howl, the mountain will never bend to it (Chinese Emperor, Disney's Mulan). True that the grass that bend with the wind will never break (Confucius?), and probably sleeps better, and get to keep his job too, but I don't think adapting to the market and the general public opinions, or merely be contrarian to it, is what adaptation for survival ought to be, not in the stock market.

You can't outperform the market if you think and adapt and act like them... you just have to do what you think is right, and if the market think the same, cool.. .else...

I guess we'll get to find out if your approach is well adapted to survive the current circumstances and evolve - or not. The only animals and plants that did not evolve are...fossils...often embedded in mountains.

 

[luutzu]

I guess we'll get to find out if your approach is well adapted to survive the current circumstances and evolve - or not. The only animals and plants that did not evolve are...fossils...often embedded in mountains.

I know i've tried to be funny and all but seriously, do you think a fit investment approach should be adaptable to the given situation?

To adapt could mean two things: to know what you are doing, know what the others are doing, and to act or not act when you see or understand the situation; The other adaptation is to follow the current trend, go along with what's generally accepted in the environment - the kind of adaptation from a biological, survival stand point.

When it comes to investing, the first adaptation is, i think, better; the second is mere survival - kinda like benchmarking against some index, or buying some blue chip because everyone else is doing it.

In application to finance, when a guy comes to you and offer $100 for X, the first approach will say... "No thanks, I reckon it's worth no more than $50, and I don't care if others will fight to get it off me for $150 next week."; The second adaptation will be: "awesome, i know a few people who will pay at least $150."

And if an approach is already successful, why would it evolve?

"To change or not to change is not important. What is important is whether it is necessary to change, whether the change will be beneficial." - Han Fei Tzu [I also got a Western Quotes for every occasions ]

 

[DeepState]

And if an approach is already successful, why would it evolve?

"To change or not to change is not important. What is important is whether it is necessary to change, whether the change will be beneficial." - Han Fei Tzu [I also got a Western Quotes for every occasions ]

You are free to think whatever you like and apply whatever approach you think is right for investment. Why not let it roll and see which of wealth or extinction comes first.

 

[craft]

Being on the other side of Luutzu's transactions

 

[luutzu]

Being on the other side of Luutzu's transactions

that's a good one

also true... I sold CBA a while back for $35 or so and it's now $71? Sold CSL at $42 and a few years later it's $60?... Sold Coles Group two weeks before Westfarmers made the offer

Although I did get one win on some unlucky dude who bought a stock to be taken over at $1.10 for $1.105...