To determine the return potential of any trading strategy you have to look at three things, edge, frequency, and position size.
Edge is your ability to forecast future returns in the market with an accuracy better than random guessing.
Edge is a concept that decades of trading literature have beaten to a pulp. You’ve heard it a million times:
“You need a positive edge to win long-term.”
And it’s absolutely true.
In trading, edge is your ability to select trades that perform better than random.
You can think of edge as the process used to generate and execute entry and exit signals. Professional traders spend a majority of their time on this process alone.
They’re constantly asking themselves questions like:
How can I refine my research to enter the absolute best fundamental plays?
How can I better time my exits and entries using quantitative cues?
How can I cut my losses through improved exit parameters?
The more they improve their entry and exit signals, the stronger their edge becomes.
To increase your own edge, relentlessly search for holes to plug in your trading process. This could involve a stronger focus on improving your fundamental analysis. Or maybe refining your profit taking approach. It could also mean tighter risk management or really any number of other factors that go into an effective trading strategy.
The stronger your edge, the more profitable you’ll be.
Frequency is how often your edge shows up.
And position size is how much you can bet on each trade while remaining emotionally stable.
A large edge that shows up frequently and can handle large position size will produce the highest returns.
