Thread by @therobotjames

Allow me to ramble for a bit about how I think about edge in trading. 👇👇👇

First, what we're trying to do is trade deviations from fair value.

We want to repeatedly:
- buy what's cheap
- sell what's expensive
- offset risk as cheaply and efficiently as possible.

1/n

We'll concentrate on the first two here.

Let's take a really simple example to start with. Imagine you have the same asset trading on two different exchanges.

Let's pretend it's some altcoin trading on two crypto exchanges (cos I want to look cool.)

2/n

Remember we want to be trading deviations from fair value?

Well, I don't have a clue what the fair value of some altcoin should be.

But maybe I don't need to.

I can certainly identify when it might be *relatively* cheap or expensive on each exchange.

3/n

In this case, it makes sense to think about the *spread* - the difference between the two prices.

I can't get a decent fair value for the asset itself, but I can get a fair value for the spread.

Ignoring real-world frictions, risks etc the FV of the spread should be $0.

4/n

(Spread = price at Binance - price at OKEx)
I drew it badly but you probably get the idea.

Now we've got a clear idea of how we might trade this - at least in our frictionless world.

We want to be short the spread when it's above fair value and long when it's above.

5/n

We can estimate the expected value of the position as the distance between the spread and the $0 fair value line.

This is useful because this isn't going to be the only thing we're trading.

6/n

If the EV of getting short this spread is only 5% annualised and we have a 50% annualised opportunity elsewhere - we're not going to be trading this.

Or, at least, we won't be trading it in size.

7/n

Our general trading problem (at least in terms of edge) becomes to:
- identify deviations from "fair value"
- pick the best ones
- hold them until there are other opportunities with better expected returns available.

8/n

"Hang on a minute," you say. "You picked a totally trivial example of the same thing trading in two different places and different prices. It's easy to know how to trade that, but most things don't look like that."

True true.

9/n

But the concepts are the same, it's just harder to model the fair value line.

You need some skill in determining fair value, either through:
- quant skills - such as modelling lead/lag effects to other assets, corrs to a basket, liquidations etc
- discretional skill

10/n

So now we take a leap and assume you can calculate a fair value line.

Plot FV and the tradeable price of the asset..

Now the FV line is no longer anchored to $0 - but we can still work out the expected value as the difference between FV and the price you can trade.

11/n

And if it helps you picture things, you can just plot your expected value of holding a trade till it had no edge anymore...

Which is the equivalent of what the chart would look like if you flattened the FV line to be a horizontal line at $0, like before.

12/n

This is, essentially, the whole "edge" side of active trading.

You're normalising all your opportunities as best you can vs "fair value" (which is easier to do with spreads / relative opportunities - but noisily possible everywhere with skill.)

13/n

Then you're trying to hold the opportunities with the highest expected value.

And when the expected value of your positions isn't as attractive as others, you rotate into more attractive opportunities.

This is the conceptual side of "edge".

Conceptually, it is simple.

14/n

Practically, of course, it is not so simple.

There is a lot of measuring and modelling and adaptation to be done.

And when it comes to trading you have to think about risks and other constraints. (Which is usually the bigger problem.)

But this is the basics of edge.

15/15.

Further related reading:

https://twitter.com/therobotjames/status/1369787449694584835?s=20

https://twitter.com/AgustinLebron3/status/1363876629550800901?s=20

https://twitter.com/therobotjames/status/1369787449694584835?s=20