The wide ranging subject of what is a trading edge and how you can use it to profit when trading markets, is one of the most actively discussed subjects, on many FX trading forums. A trading edge can be defined in many ways, in simple terms it’s a repeating pattern of market behaviour, which you identify, that you can take advantage of, in order to profit. A highly revered publication, Investopedia, defines a trading edge as: a technique, observation or approach, that creates a cash advantage over other market players. It doesn’t have to be elaborate to fulfil its purpose; anything that adds a few points to the winning side of an equation, can build an edge that lasts a lifetime.
A common mistake, which traders of all levels of experience make, is to imagine an edge always happens; day after day, week after week. Or that it’s a bullet proof, 100% method, to always profit from. They also make the mistake of surmising that; whenever the pattern of market behaviour occurs, they’ll always profit, using the same trading technique and strategy, day after day.
When in reality, your edge might only offer up the chance of generating profit 60% of the time, when your perfect trade set up (your edge) actually occurs. The circuitous debate then begins in your mind with regards to the overall the reliability of your possible edge, if it doesn’t ‘work’ 100% of the time. These doubts can generate indecision and insecurity amongst traders, as they consider disposing of their edge and recommencing their search.
Doubt creeps in on the days when your edge simply doesn’t work. And if your potential edge doesn’t work for a series of days, you may consider abandoning your quest for an edge, as the reality escapes you that what you’re in fact experiencing, is entirely normal as the market (at times) can deliver a highly random series of results. There will always be a series of days when your edge is incompatible with the prevailing market conditions, but that doesn’t render your edge and overall strategy redundant. Only experience will teach you this fact, which is why you have to develop unwavering belief in your edge, before committing it to live trading.
Before applying (what you think is) your edge into live trading situations, it’s advisable to back test your theory. Then, once you’re convinced it’s an edge and a potentially workable strategy, you can then apply the strategy into live testing, perhaps by using drastically reduced size, with micro and mini FX lots. Once you’re convinced your edge is viable, you can begin to increase your size. But once you’re confident the edge will work, you still have to sharpen and modify it, in order to accommodate constantly changing and evolving market conditions.
Let’s surmise that you’d identified a simple edge that you become convinced has potential, we’ll use the following suggestion as a simple and straightforward example. We’re going to limit it to one security only, EUR/USD, the most traded and therefore, the most highly liquid currency pair.
As a day trader, you note that if you take a long trade when EUR/USD is bullish, or if you short the security when the pair is bearish, you stand a greater chance of being proven right. You determine the bullish or bearish sentiment by the simple use of the daily pivot point and Heikin Ashi candle stick formations.
In short; if you see a closed one hour candle, with an upward wick on the one hour time frame, when price is above the daily pivot point level, you surmise that bullish conditions exist. You then feel confident in taking a long trade. You can reverse the strategy for bearish trades. Is this your edge? It could be, however, until you’ve executed perhaps hundreds of trades, over a protracted period of time (perhaps months), you can’t judge the strategy as an edge, it’s more of a work in progress, a possible edge.
But let’s head back to your theory and determine how we could sharpen up the possible edge. Simply observing that EUR/USD is more likely to remain bullish above the daily pivot line when a one hour H.A. candle forms, is not enough. You have to establish the probability of that theory developing into an edge and you can only do this by deciding what risk you’ll attach, to each and every trade.
So on the basis that you take your long trade when the bullish conditions’ set up occurs and exists, where will you place your stop, in order to limit your risk on each and every trade? Will you place it at the daily low, perhaps below the daily pivot point level? Based on the assumption that if this level is taken out, then the bullish conditions have evaporated and the bears are in control. Or, will you remain attached to a fixed stop? You take the trade, but if EUR/USD falls below this fixed stop, perhaps by 20 pips, then your trade will close out at a loss. Or will you use, through your MetaTrader platform, trailing or dynamic trailing stops? Stops that move with your open trade, as market conditions alter.
As you can clearly see, identifying potential edges can be simple. However, it’s how you apply both yourself and the edge into the marketplace, which is key to determining if the potential has credibility. You can only do this through engaging in a comprehensive testing period, during which you establish how you’ll limit your risk, on each and every trade.
Because it’s not just the sure fire proof that perhaps, during bullish conditions, taking bullish trades might work, it’s how you look after your bottom line, through the use of stops to limit your risk, that might ultimately determine if what you think is your edge has potential.
