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Trading with an edge

In order to be a successful trader, you need to understand that trading starts with having an edge in the markets.

The biggest mistake new traders make is assuming that making sole use of things such as indicators will allow them to become a successful trader.

There is much more to it. The basis of trading starts with identifying an edge in the market. Only after you have identified an edge should you then go on to use such things as indicators to help you make trading decisions.

What is a trading edge?

A trading edge in the financial markets can be described as a set of conditions that when present, give a higher probability of a trade working than not working.

An example of an edge could simply be identifying when the market is trending, in which case you base your trades on the direction of the trend. If you take trades in the direction of the trend, you have a higher probability of producing profitable trades.

Despite having an edge, there will be losing trades as well as winning trades. Trading in the direction of a trend does not guarantee a winning trade, merely a higher probability of a trade working out. The first trade that you take in the direction of the trend could be a losing one. However, taking a series of trades in the direction of the trend is likely to result in trades that win.

Winning and losing trades are randomly distributed

Fundamentally, winning and losing trades are randomly distributed, and a trader must take multiple trades to ensure they incorporate winning ones. If you base a series of trades on an edge that you have identified, then the probability of having winning trades increases over time.

A trading edge in the financial markets can be described as a set of conditions that when present, gives a higher probability of a trade working than not working.

 

A further example of a trading edge could also be that you are able to recognise when the market is ranging and so you can then buy at the lower boundary and sell at the upper boundary of that range. Notice in the chart below that a trend and a range have been identified in the same chart:

  1. You can take trades in the direction of the down trend. 
  2. You can enter buy positions at the lower boundary of the range and sell positions at the upper boundary of the range.

Building on a trading edge

Once you have identified an edge, the focus is how to recognise these market conditions more easily and how to trade in them. That is when you can start to seek signals from such things as indicators, to provide buying and selling signals based on these conditions.

Consider the following chart where the market has been identified as a ranging market: 

The edge in the above scenario, is that the price is trading in a range – the price is more likely to fall at the upper boundary and rise at the lower boundary. Based on this edge, you can use an indicator, such as the stochastic indicator that signals when the price has reached the upper or lower boundary.

  1. The stochastic indicates when the upper boundary has been reached and so therefore this produces a selling signal. 
  2. The stochastic indicates when the lower boundary has been reached and so therefore this produces a buying signal.

These trading signals are still based on probability. In other words, if your indicator is producing a buying signal, then this does not mean the price will go up, it means that there is a higher probability of the price going up than going down in the current market conditions.

Remember: Indicator signals are still based on probability. If your trading system produces a buy signal, it only means there is a higher probability of the price going up.

 

The truth is, once you enter the market with any given trade, you are at the mercy of the markets. This is where a system or a strategy comes into trading. A strategy is a set of rules that you trade by and those rules are based on identifying an edge and then trading accordingly.

This means that it does not matter if the trade wins or loses, because if you trade with a strategy based on an edge, then your trading system will produce winning trades over time that will make up for the losses. Of course this is not the whole picture, because you must take into account risk to reward and money management. However, when you have an edge, you have a starting point in which you can then begin to build a system.

Now that you have been introduced to the fact that successful trading is based on an edge, the following lesson will demonstrate how to start building a system or strategy based on the edge you have identified.

 

Summary

So far, you have learned that ...

  • ... a trading edge is when you can identify a set of market conditions that give a higher probability of a trade working than not working.
  • ... an edge can be identifying when the market is trending, in which case you take trades in the direction of the trend
  • ... an edge can be identifying when the market is ranging, in which case you can buy at the lower boundary of the range and sell at the upper boundary of the range.
  • ... there is a random distribution of winning and losing trades and you must take a series of trades over time.