07/25/16 ~ MEGHA CAPITAL'S Blog

Jul 25, 2016

What is a trading edge? How to get a trading edge for success in trading ?

A trading edge is defined as a set of conditions which result in a net gain when used over a large number of trades.

Let us think of a casino. The gambler can win once , or can win many times. But, if he gambles for a long period of time, he is going to lose money because the Casino receives Rs 100 and pays out Rs 97. The Casino has an edge. In the long run, the edge will show itself resulting in a guaranteed loss for the gambler.

In trading, nothing is guaranteed. Yet, traders must have some idea that the trading strategies they use will have more gains than losses over a long period of time. That is the trading edge.

No single trade will provide you with information on your edge. A series of trades may be profitable or losing purely by chance. When you take a statistically significant number of trades then the trading edge should come in play.

If you have made just five trades in the Nifty and all of them were profitable then that is probably by chance - a random event.

Suppose you trade a 100 times in the Nifty futures over one year. Now, 100 is a significant number of trades. If you make money after an year, then you probably have an edge.

All trading should start with an edge.

In the next post, we will examine how we can determine if we have an edge in trading.

HOW DO YOU KNOW YOU HAVE A TRADING EDGE ?

1. Your trading edge should be confirmed by statistical analysis.
This way is the easiest to apply and the most difficult to create. If you have a statistical analysis of your trades then you know for sure if you have an edge. Suppose you have recorded the details of actual trades taken over a period of three years. There are five hundred trades and you have the reasons for taking each trade, together with the the gain or loss per trade. Putting this data into Excel can give you a complete statistical analysis of your performance. If you are making more money than you lose, with a reasonable upward sloping equity curve, then you have an edge.
But that was the easy part. The difficult part is to have actually kept a record of your trades. Suppose you did not keep a record. Then what do you do? Then we come to the other methods.

2. Back-Testing a mechanical trading system.
You may be trading with a mechanical trading system - a method that has a set of rules and these rules have been tested on past data. If your trading rules can be tested over previous / past data, then do so. The results of the back test with give you some idea if you have an edge or not. If the performance over the data period is satisfactory then at least you have an edge in the past.

3. Be consistent.
if you are not using a clear set of rules which can be back tested, then this one is for you. You should be consistent with your trading method. Follow the same set of rules for all your trades. Chances are that your consistency will ensure that you have an edge.

Dennis Gartman's Trading Rules

1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.

5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

6. "Markets can remain illogical longer than you or I can remain solvent," according to our good friend, Dr. A. Gary Shilling. Illogic often reigns and markets are enormously inefficient despite what the academics believe.

7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.

8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.

12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.

14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.

15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.

16. Bear markets are more violent than are bull markets and so also are their retracements.

17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.

19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.

20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this twenty five years ago and it holds truer now than then.

21. There is never one cockroach! This is the "winning" new rule submitted by our friend, Tom Powell.

22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!

Bernanrd Baruch's 10 Investing Rules

1. Don't speculate unless you can make it a full-time job.

2. Beware of barbers, beauticians, waiters — of anyone — bringing gifts of "inside" information or "tips."

3. Before you buy a security, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth.

4. Don't try to buy at the bottom and sell at the top. This can't be done — except by liars.

5. Learn how to take your losses quickly and cleanly. Don't expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.

6. Don't buy too many different securities. Better have only a few investments which can be watched.

7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.

8. Study your tax position to know when you can sell to greatest advantage.

9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.

10. Don't try to be a jack of all investments. Stick to the field you know best.

James P. Arthur Huprich's Market Trusms And Axioms

1. Commandment #1: "Thou Shall Not Trade Against the Trend."

2. Portfolios heavy with underperforming stocks rarely outperform the stock market!

3. There is nothing new on Wall Street. There can't be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again, mostly due to human nature.

4. Sell when you can, not when you have to.

5. Bulls make money, bears make money, and "pigs" get slaughtered.

6. We can't control the stock market. The very best we can do is to try to understand what the stock market is trying to tell us.

7. Understanding mass psychology is just as important as understanding fundamentals and economics.

8. Learn to take losses quickly, don't expect to be right all the time, and learn from your mistakes.

9. Don't think you can consistently buy at the bottom or sell at the top. This can rarely be consistently done.

10. When trading, remain objective. Don't have a preconceived idea or prejudice. Said another way, "the great names in Trading all have the same trait: An ability to shift on a dime when the shifting time comes."

11. Any dead fish can go with the flow. Yet, it takes a strong fish to swim against the flow. In other words, what seems "hard" at the time is usually, over time, right.

12. Even the best looking chart can fall apart for no apparent reason. Thus, never fall in love with a position but instead remain vigilant in managing risk and expectations. Use volume as a confirming guidepost.

13. When trading, if a stock doesn't perform as expected within a short time period, either close it out or tighten your stop-loss point.

14. As long as a stock is acting right and the market is "in-gear," don't be in a hurry to take a profit on the whole positions. Scale out instead.

15. Never let a profitable trade turn into a loss, and never let an initial trading position turn into a long-term one because it is at a loss.

16. Don't buy a stock simply because it has had a big decline from its high and is now a "better value;" wait for the market to recognize "value" first.

17. Don't average trading losses, meaning don't put "good" money after "bad." Adding to a losing position will lead to ruin. Ask the Nobel Laureates of Long-Term Capital Management.

18. Human emotion is a big enemy of the average investor and trader. Be patient and unemotional. There are periods where traders don't need to trade.

19. Wishful thinking can be detrimental to your financial wealth.

20. Don't make investment or trading decisions based on tips. Tips are something you leave for good service.

21. Where there is smoke, there is fire, or there is never just one cockroach: In other words, bad news is usually not a one-time event, more usually follows.

22. Realize that a loss in the stock market is part of the investment process. The key is not letting it turn into a big one as this could devastate a portfolio.

23. Said another way, "It's not the ones that you sell that keep going up that matter. It's the one that you don't sell that keeps going down that does."

24. Your odds of success improve when you buy stocks when the technical pattern confirms the fundamental opinion.

25. As many participants have come to realize from 1999 to 2010, during which the S&P 500 has made no upside progress, you can lose money even in the "best companies" if your timing is wrong. Yet, if the technical pattern dictates, you can make money on a short-term basis even in stocks that have a "mixed" fundamental opinion.

26. To the best of your ability, try to keep your priorities in line. Don't let the "greed factor" that Wall Street can generate outweigh other just as important areas of your life. Balance the physical, mental, spiritual, relational, and financial needs of life.

27. Technical analysis is a windsock, not a crystal ball. It is a skill that improves with experience and study. Always be a student, there is always someone smarter than you!