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How to develop a trading edge: nine steps towards trading success

Whether you are short-term day trading or long-term investing, finding a trading edge is an essential part of building a strategy to achieve market beating returns and become a profitable trader. In this article, we explain what a trading edge is, the different types, how it is calculated, and how to come up with your own.

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What is a trading edge and why do I need one?

A trading edge is a trading method, or approach, that helps to accumulate more profits than losses. An edge can be a strategy, technology, psychological fortitude, persistence, understanding of market movements, risk control, or basically anything that allows someone to succeed in making profits where many others fail. It is what separates winning traders from losing traders.

Those without an edge may win trades occasionally, but they are unlikely to profit consistently. An edge is necessary, otherwise a trader is essentially donating their money to the market.

When starting out, most traders don’t have an edge, and they see their account dwindle initially. But as they improve their skills – strategies, consistency of approach and mental game – they begin to develop an edge and profits may begin to flow their way. The bigger the edge, the bigger the profits tend to be.

Examples of trading edges

A trading edge can be a strategy, but it can also be a personality trait or skill that keeps losses smaller while trading. Losses are guaranteed to occur, so an edge either helps you win more trades, or it may help to win big when you do win and keeps losses small when you do lose.

For example, a trader may study a stock, commodity or forex pair and have pre-planned ideas about how various news announcements may affect the price.

They are ready to act when these are released, as part of a news trading strategy, which makes their edge acting before others. They have done their homework and know what to do if the news is bullish, bearish (and to what extent), or neutral. Others are planning after the news hits, while this trader already knows.

Another trader may have an edge where they always cut losses if the price drops a certain amount, such as 5%, but they don’t take profits until they are up at least 15%. Wins will therefore always be bigger than losses. A favourable ‘risk/reward ratio​’ is an edge.

In another instance, a high-frequency day trader employs technology to their advantage. They use computers and programs to rapidly enter and exit positions for tiny profits that add up over the course of a day.

Another trader might simply notice that a certain pattern tends to occur before some big price moves. They exercise patience and only wait for that specific pattern to emerge. While not every trade is a winner, on average, the pattern makes them money, especially when combined with a favourable risk/reward.

9 steps for finding and defining your trading edge

There are many trading edges, and each person finds their own differently. The following tips will aid you in developing or finding a trading edge.

1. Educate yourself in the ways of the market

Learn about what moves prices and how prices act. In particular, learn as much as you can about trading strategies that you are interested in, such as scalping, day trading, momentum trading, technical analysis, or fundamentals, for example.

You don’t need to know everything, but to trade successfully, it’s a good idea to familiarise yourself with as much information as possible. For example, a trader who focuses only on one chart pattern needs to have some knowledge on how the price acts before, during and after it is formed. They may then become an expert by reviewing many charts, taking notes, and then practising their approach with a risk-free demo account.

If you are unsure what style suits you, read a wide range of material on trading and investing. When something resonates with you, delve deeper into that topic. Then you can start building your own personal edge with what you learn. It is best to build a personal edge because each person is different, and it may not always be possible to copy someone else’s edge, strategy or trading style.

2. Develop your strategy

When you have a clear focus on how you want to trade, begin developing a strategy around it. A strategy is a method or formula that is repeatable and tends to yield favourable results over many trades (as no strategy wins every trade). Consider customising a strategy you have read about or combining other people’s strategies that you think might work for you. This is a form of social trading, which can be observed on our Next Generation platform.

For example, a day trader may look for specific patterns that occur at certain times of the day. They may enter a trade when technical indicators reach certain levels or near the start of the day if they expect there to be strong (buy) or weak (short) price action based on overnight news or price gaps.

A long-term investor may look at the types of fundamentals present in companies that see a significant stock price rise over several years or more. To do this, they might first find stocks that have had big rises over the last five years, for example, and then look at those company’s fundamentals for commonalities.

A strategy includes how and when you will enter a trade, plus when you will cut or take a loss or profit. You will also want to consider the position size, or how much of the asset you will buy or sell at a time.

3. Test your strategy

With a strategy defined, or at least the basis of a strategy, the next step is to test it. Try to find as many examples of the strategy working on charts as possible and then add up its wins and losses. If it was profitable over many trades, the strategy has a potential edge. Test it in a demo account using manual backtesting​ or paper trading​, which involve writing down trades that you would have taken to track the hypothetical results.

For an investor or trader, this means looking at securities that performed well recently, then also looking back at stocks that performed well historically. Would the strategy have captured some of these big winners without also including too many losers?

For a day trader, they will go through many historical days looking for a chart pattern or indicator configuration. Since you know where you will enter and exit, you can add up the potential profit or loss of the trades found.

One of the best ways to test your strategy is in real time, putting your strategy and execution skills to the test with either a risk-free demo account or a fully funded live account, where you can realise the profits of any trading edge you’ve discovered.

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4. Refine your strategy

A strategy may work well, or you may run into some problems. The strategy may not be profitable, for example, but that doesn’t mean all is lost. Look at how profit could have been made on more trades.

Possibly, slightly expanding the stop-loss order could have kept you in for more big wins, or possibly holding on longer to some big winners could tip the strategy into profitable territory. Perhaps there are too many losing trades, so consider how some of these could be eliminated without also cutting out too many winners. This is where you use what you’ve learnt from testing your strategy to tweak and improve your approach.

5. Manage your risk

With any strategy, risk-management is important. While a stop-loss can help to minimise losses, consider how much you are willing to lose per trade. Many professional traders opt to risk 1% or less of their account per trade. For example, if they have a $10,000 account, this means they won’t lose more than $100 on a trade.

Limits may also be set on how much can be lost in a day, week, month, or the account as a whole. For example, a day trader may stop trading for the day if they lose 3% of their account. Meanwhile, a swing trader may stop trading for a week, for example, if they lose 20% of their account. Such risk-management rules keep a bad day or a losing streak from depleting the account too rapidly.

6. Understand trading psychology

Having a strategy is important, but a trader must be disciplined otherwise it is useless. Trading psychology is the field of mental performance. Traders need to be able to execute their strategy in changing market conditions. They must act when required and during the rest of the time, avoid placing trades that don’t meet the strategy parameters.

Traders have emotions and these can cause us to miss trades, take too many trades, doubt ourselves, or be overconfident. All can be equally detrimental. To combat this, you could note down the emotions you feel while you are trading and keep track of the ones that seem to cause issues. Consider keeping a journal of why you feel this way and what you could do to stop the emotion from interfering with your profitability. Reading books and watching videos on trading psychology can help to generate more ideas.

7. Keep a trading journal

A trading journal contains the thoughts and insights of a trader at the time they are trading, alongside the details of each trade; for example, entry and exit prices, stop-loss levels, risk/reward ratios and whether it resulted in a win or a loss. For example, a day trader may write in their trading journal after they finish for the day, noting what they did poorly and how they could improve, what they did well and how that could be leveraged.

A trading journal may also track new strategy ideas or market tendencies that were noticed while trading. It can take on many forms but is usually a personal notebook that helps the trader improve. The format and contents may include anything that aids this improvement and boosts the trading edge.

8. Calculate your trading edge

It is helpful to quantify a trading edge, which can be done using a formula. There are multiple formulas that help quantify a trading edge.

Positive expectancy is one such formula. It determines if, on average, taking a trade with a certain strategy produces a profit.

Expectancy = (win rate x average win) – (loss rate x average loss)

Win rate is the percentage of winning trades, as a decimal. This is ascertained from the testing or trading phase. Loss rate is the percentage of losing trades, as a decimal. Average win is the average profit on a trade. To find this, add up all wins and divide by the number of wins. Average loss is the average loss on a trade. To find this add up all losses and divide by the number of losses.

This formula is useful because, to calculate it, you must know how often your strategy wins and losses (win rate) and your average win and loss size (risk/reward). These statistics on their own are very telling.

If you have a low win rate, your profits must be much bigger than your losses to have a positive expectancy. If you have a high win rate, your wins can be smaller relative to losses and still maintain a positive expectancy. You could tweak and improve win rate and reward/risk to improve expectancy.

9. Be patient, rinse and repeat

Consistently profitable trading doesn’t come overnight. Take steps for your long run to success, using the previous eight tips to find your trading edge. Developing a strategy that works for you may take multiple attempts. Keep researching and coming up with ideas, testing, refining, and working on your mental game. The pay-off will come once you find a strategy that you have a positive expectancy with, and you can keep using it repeatedly.

As you come up with new strategies over time, go through the same process with each one to make sure it provides an edge and the best chance at being a profitable trader.

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How long might a trading edge last?

How long a trading edge lasts will depend on the method. Some may last a lifetime or longer, while others may work for a while and then stop working. There is no way to know what will work in the future. The good news is, once a trader has developed a profitable trading strategy​​, they likely know how to develop another in case one stops working.

How can I optimise my trading edge?

To optimise your trading edge, go through the above tips and keep researching and learning. Develop, test and refine your strategy. Use a trading journal to help you understand trading psychology and ultimately optimise your edge. Read our article on building an effective trading plan​.

Can I ever be sure that I have a real edge?

You only know if you have an edge when it produces results, but you also don’t know if your ideas or strategies will keep working in the future. The more data you test, the more trades you can tally up and plug into an expectancy formula with favourable results, the more likely a strategy is to keep working. For example, you could use a backtesting strategy for this.

How can probabilistic thinking help me gain an edge?

Probabilistic thinking is helpful. If something works 60% of the time, there is a potential trading edge. If you can win three or four times as much on winners compared to losers, there is a potential edge there. Trading is all about finding probabilities that work in your favour.

Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.