A Statistical Edge in Trading is a Strategy or System With Positive Expected Value:
When people try to find or develop a statistical edge for trading stocks, options, futures, forex, cryptocurrencies, or whatever they prefer, they often latch onto win rates – immediately assuming that a 50%+ win rate automatically equates to a winning system.
But what often gets overlooked is the fact that win rate is only part of the equation, and in many cases, doesn’t tell the whole story. Believe it or not, a trader can have a 90% win rate and still have a losing system. So don’t take win rate as the ultimate gauge.
On the flip side of that, a trader can have a 10% win rate or lower and still have a winning system. So there are obviously other critical components to consider. The average sizes of your wins and losses can’t be ignored – they have to be factored in.
All over the internet you’ll find traders boasting about their high win rate systems, even if those high win rates don’t necessarily equate to long-term profitability. I guess the idea of having a 70%, 80%, or even 90% win rate system is more important than making money.
But the truth is that most consistently profitable traders have a win rate somewhere in the 40-60% range. This doesn’t sound exciting to the majority of individuals looking for trading systems, which is how they end up down the ineffective get-rich-quick path.
So you have to be realistic and understand the concept of expected value. Win rate is important, sure, but not the sole ingredient.
The Expected Value Equation With Examples of Winning and Losing Strategies/Systems:
The expected value equation is fairly simple, yet critical for all traders to understand because it measures your expected return on a per trade basis. The four pieces of information needed to calculate it are win rate, loss rate, average win, and average loss.
Expected Value = (Win Rate x Average Win) – (Loss Rate x Average Loss)
If we take a trader with a 90% win rate like I mentioned earlier, we can see how an incredible win rate doesn’t necessarily produce profits. For example, let’s say this trader’s average win is $100 and average loss is $1,000. If we pop these numbers into the expected value equation, this trader can expect to lose ten dollars per trade [EV=(.90 x $100)-(.10 x $1,000)=$90-$100=-$10].
Now if we flip the script and take a trader with a 10% win rate, average win of $1,000, and average loss of $100 – we can see that it’s possible to be a profitable trader with a seemingly terrible win rate. This trader could actually expect to make $10 per trade on average [EV=(.10 x $1,000)-(.90 x $100)=$100-$90=$10]. Clearly, expected value is what tells the whole story – win rate alone doesn’t.
When boiled down to its simplest form, the concept of trading success is fairly straightforward. All it takes is two main components: 1) a statistical edge/positive expectancy system, and 2) your ability to capitalize on that edge/follow the system. But effectively combining these two components becomes complicated within the dynamic, uncertain, impersonal and limitless market environment.
In my experience, it’s on a psychological level where most traders break down. In other words, it’s not the statistical edge that’s hard to find, but rather the ability to capitalize on that edge with emotional stability and consistency that’s difficult to accomplish.
The Law of Large Numbers – Thinking in Probabilities and Staying Resilient Through Streaks:
One of the most difficult hurdles for new traders to overcome is changing from thinking in certainties to thinking in probabilities.
Naturally, we like to think in certainties because it reduces confusion. Things are either hot or cold, right or wrong, light or dark, good or evil, etc. Thinking this way helps bring clarity to our minds, but it’s destructive within the market environment.
Since the market is inherently uncertain, nothing is guaranteed. So when you go out searching for a system that “works”, understand that “works” doesn’t mean 100% of the time. You have to adopt a probabilistic mindset in order to operate effectively.
With that being said, the law of large numbers essentially states that probabilities will work themselves out over many instances. So even though a coin flip, for example, has 50/50 odds – it doesn’t mean you can’t flip heads 10 times in a row by sheer chance/luck.
This is the sort of thing that derails many new and inexperienced traders. They have their system with a positive expectancy, but give up on it after just a few losing trades in a row. Streaks like this are a perfectly normal occurrence, but hard to overcome mentally.
When things don’t go exactly as expected or desired, the average person will break their rules by removing stop losses or doubling-down on losing positions, get mad at the market and revenge trade, or give up on their system and strategy-hop.
This is just a short list of many impulsive, irrational, and overall destructive trading behaviors. Which is why it’s so important to avoid short-term gratification at the expense of your long-term trading success. Over time, probabilities work themselves out.
Conclusion – Your Statistical Edge and Trading Skills Are Essential For Durable Market Success:
Once you find or develop a statistical edge, don’t assume that the work ends there. Market conditions can always change and render your current system ineffective. This is a mistake that many new traders make – failing to adequately adapt to the market.
There is no system that performs exactly the same in every type of market – down-trending, up-trending, sideways, volatile, nonvolatile, etc. So you also have to understand how your statistical edge fluctuates depending on current market conditions.
This is where closely tracking your trades and analyzing the data can help you pinpoint when your system is performing at its best and possibly even avoid trading the system at certain times. You might also be able to refine your stop losses and profit targets.
These are the intricate details of trading success that most fake trading gurus on the internet tend to ignore because they want you to think that trading is easy – and that they have some “foolproof indicator” that generates nothing but profits.
But the reality is that simple patterns aren’t the answer. It takes a combination of core trading skills to be successful. It’s not depending on some self-proclaimed expert to tell you what to buy or sell. It’s building technical, analytical, and mental skills for self-sufficiency.
In the end, a statistical edge is required for consistent success, but that edge will undoubtedly be compromised without proper skills.
Learn More in the Trading Success Framework Course
Written by Matt Thomas (@MattThomasTP)
- What is a Day Trading System? Establish Structure in Your Approach
- What is Trading Expectancy? The Importance of Having a Statistical Edge
- How Much Money Do Day Traders and Swing Traders Make?
- What is Good Stock Trading – Good vs. Bad Stock Trading
- What is the Core of Trading? It Boils Down to a Simple Equation