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Every trader should understand their edge in their trading. If we have an edge, we have the ability to make a profit trading the financial markets. In this article, I look at how to quantify this edge.
I analyse four different technical indicators and see how they have performed as a short-term entry signal on the S&P 500.
A Good Trading Strategy
A good trading strategy must generate a profit. At a minimum, this profit must allow us to:
- Pay for all the losing trades
- Pay for the cost of trading
- Generate a return that is proportionate to the time and money invested in the strategy
- Generate a return that is proportionate to the amount of risk
When we are developing a trading strategy we obviously want to know that it has an edge. However, it can be difficult to be sure whether this edge is genuine or not.
What is a Trading Edge?
A trading edge is an advantage that we can use to make our strategy profitable. This advantage might be to identify high probability turning points or continuation areas. An edge might be a single factor or a combination of factors.
A trading edge will vary by market, by timeframe and by trading strategy. A trading edge might work on one market but not in another.
In this article, I am going to focus on getting an edge with a trade entry.
Looking at the Charts
Humans are great at spotting patterns. This ability helps traders to identify all sorts of shapes and patterns in their charts. This might be a technical indicator crossover, double-top or Japanese candlesticks.
However, our eyes are naturally drawn to the points where the price changes direction. We automatically filter out the times when the trading signal did not work.
Looking at charts is therefore great for identifying a potential edge. But not as good at telling us whether this edge has been able to beat the market over the long-term.
How to Calculate Your Edge
To calculate the edge we need to have some way of studying what has happened in the past.
One way to do this is to scroll through a chart and keep a list of what happened whenever our edge occurs. This is absolutely fine but it needs to be done very carefully and it takes a lot of patience.
I prefer to use some form of analysis software. I carried out my analysis using a Tradinformed Backtest Model. These are built using MS Excel and are a great way to test all sorts of different trading strategies. They can be used with technical indicators, Japanese candlesticks and chart patterns. They are quick to set up and allow you to test lots of different variables.
Technical Indicator Edge Analysis
I did a simple test of four popular technical indicators: Stochastic Oscillator, RSI, MACD and Bollinger Bands. If you want to know how to calculate these, I have an eBook available: 21 Technical Indicators.
The test was carried out on the S&P 500 on the daily timeframe between 1996-2015. I looked at long-only trades. To compare each indicator I set up a time close. In the first scenario I closed the trade after one day. In the second scenario I closed the trade after two days. In the third scenario I closed the trade after three days. The entry signals were:
- Stochastic Oscillator – Indicator crossed above the 20 line
- RSI – Indicator crossed above the 35 line
- MACD – Indicator crossed above the 0 line
- Bollinger Bands – Price crossed above the lower Bollinger Bands
The results showed that out of the four technical indicators, only Bollinger Bands showed a positive edge in the scenarios tested. To me this makes Bollinger Bands worthy of further investigation.
Regarding the other three technical indicators, I was surprised that the RSI was the worst performer. I expected it to do well in this analysis.
Overall, this test is a good starting point but much more work needs to be done to see whether these results are repeatable over different markets and different timeframes.
Purchase the Spreadsheet
If you are intrigued by this test you might want to do your own trading analysis. You could test your ideas about the 5-minute bars on the E-mini or a multi-year investment strategy.
If you would like to do this you can see the latest models in the Tradinformed Shop.
If you would like some more information about this test feel free to have a look at the YouTube video that I recorded here.