How do I know if I have an edge?

A thread... πŸ‘‡πŸ‘‡πŸ‘‡πŸ‘‡

I've been helping a family friend with his trading. I've given him a simple systematic strategy to trade by hand.

We can plot the distribution of historic trade returns from past trading or a backtest as a histogram.

The trade P&L is on the x-axis and the frequency (# of trades with that P&L) on the y-axis.

This is useful because it gives us a hint as to what the "edge" of our strategy might be - if we could ever truly *know* such a thing.

In this case, our strategy had positive mean and negative skew.

We saw winning trades about 58% of the time but losers were bigger, on average, than winners.

(As many things that make money tend do, regrettably)

Now, when we make a trade, we're really just taking a random sample from a bucket of returns.

You might think of it like we're picking observations out of the bucket described by the histogram we just made.


The histogram doesn't show us the true nature of the distribution of returns in the bucket - just the returns that occurred in the past.

The "true distribution" changes with time (it is stochastic) and cannot be observed directly. We can only infer it from the past.

So the best we can know is that, in the past, it looked like we had an edge.

We might run rolling stats to try to observe the time-varying nature of things - but we'd be working with only a few samples and the variance of our trade return is large.

So we do our best to estimate what the "true process" looks like, by inferring it from past observations and our understanding of market dynamics.

Now we have set reasonable expectations about the P&L distribution, my friend starts trading...

My friend has placed about 20 trades and he's starting to try to make some distinctions based on individual trades.

"I've learned to exit later when momentum is in my favour" etc...

This is what humans do. They look for patterns in noise.

Ultimately, however, analysis at the individual trade level is meaningless.

He's just fitting stories to random data. Individual trade P&L carries no useful information.

Think about the trade p&l histogram we made at the start.

Imagine we're building that up trade by trade, observation by observation.

How many points would you need before it had a meaningful shape?

All analysis needs to be undertaken in the aggregate, ideally over as many stable observations as possible.

But everything is non-stationary (it changes with time) so our observations always arrive later than we want them to, and there are never enough of them.

This is why trading is hard and you don't get much feedback (on edge) from observing your own trades.

You get plenty of useful quick feedback on things such as market impact, but the data on "edge" takes forever to collect and stuff is constantly changing underneath you

You're extremely unlikely to make much sense of this kind of probabilistic thinking by watching the market - unless you are trading extremely fast and disciplined.

You need a quantitative approach. You need to analyze in aggregate. You need an understanding of stats

You need a critical mind. You need to understand why something works, and track whether those conditions are still in place - so you can try to pre-empt the change in the return process.

You need to understand you can never *know* if you have an edge right now.

As @AgustinLebron3 pointed out the other day, this is not something to be feared... this is what makes trading awesome!πŸ˜€

You never know if you have an edge right now, but when you think you do - sample from it as much as you can in the simplest, most robust way possible.


β€’ β€’ β€’

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More from @therobotjames

20 Sep
Steal ideas, not implementation.

I see you, with your "small but beautiful" pot of capital, trying to make it bigger.

A🧡on easy games, stealing ideas, and not competing in games you don't need to compete in.

First, the Market Gods give no prizes for difficulty.

So, to start with, you'll want to play the easiest, most reliable, hardest-to-screw-up, least-dependent-on-skill games you possibly can.

See linked thread:

Second, the Market Gods give no prizes for originality.

So you want to know what traders who are taking the game seriously are doing. (Especially with their own money.)

Proprietary trading firms
Hedge fund prop capital
Serious solo traders
Hedge funds

Read 21 tweets
20 Sep
We recently looked at VIX Futures and why they tend to trade at a premium to the VIX index most of the time.

How might you apply this understanding?

Let's discuss how you might think about a systematic VIX carry trade based on these concepts.

In the original thread we noted:
- you can't trade VIX
- so there's no market mechanism to stop it from being predictable
- but VIX futures do trade and their price incorporates where the market thinks VIX is likely to go

If the market thinks VIX is going to go up, the futures will likely already be trading at a premium.

Sellers won't sell low if it's likely to go up.
Buyers will be happy to buy higher if it's likely to go up.

Read 24 tweets
19 Sep
If you weren't there, you have no idea how disgustingly decadent pre-GFC sell side finance was.

Whatever you imagine x10.
Silicon Valley is amateur hour choirboy stuff in comparison.
Need a burner account to share stories πŸ˜‚
Read 5 tweets
14 Sep
Why do VIX Futures trade at different prices to VIX?

Derivatives can be complicated, but the answer to this question is not.

If you understand how the market prices risk then you'll know a lot without needing to know a lot.

Let's walk through it. πŸ§΅πŸ‘‡

Pull up a chart of the VIX index.…

If you're an experienced trader, you'll recognize immediately that this is not a thing you can trade.


Cos it wouldn't look like that if people could trade it.

Cos, just by eyeballing the time series chart, you can tell VIX is very predictable:

- It stays about the same in the short term
- But if it's low it's more likely to go up
- And if it's high it's more likely to go down
- It has a floor under which it's unlikely to go lower

Read 25 tweets
4 May
My focus recently has been on the crypto markets.

I don't have all the answers.

But I thought it would be useful to ramble a bit about the experience of entering a new market.

My perspective here is professional trading, but the concepts are valid for individuals too

First, you've got to work out whether it's worth expending time, effort, and money in a new market.

There's an opportunity cost associated with looking at and implementing new things.

So you put together some "high-level business case" to see if it stacks up

This can be tricky because you don't know what you don't know.

So you seek out people who are doing it and ask them to share some of their experiences.

If you are serious, people will generally be very happy to talk to you. This game isn't as secretive as you might think.

Read 16 tweets
30 Apr
Tail hedging for degenerates. Image
For most of my time, I just thought of tail hedging as the "cost of entry".

A "ticket to the dance" if you like.

You can't predict what happens in the tails - so pay up to cover them & go play hard in the peak of the bell curve, where your tools and models are most valid.
If you're a good trader, you'll tend to find that your highest expected return opportunities appear after massive moves.

Disconnections happen when others risk models are flashing red and they are FORCED to trade (rather than want to).

You want dry powder for these times.
Read 5 tweets

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