The single question that cuts the BS so you can tell if a trading strategy is genuine

 

Sharing a house with three teenage boys, I expect I’m subjected to more BS than your average person. But I also expect that your email inbox gets a fair few visits from traders and investors who are telling you about the absolute killing they’re making.

For most people, the only response to these claims is to blanket ignore them all – how are you meant to filter out the genuine from an ocean of scams?

But here I want to give you the one simple question you can ask. This will give you some unique insight into whether a trader is telling the truth, or just living in a fantasy world.

Ok, here’s the kind of stuff we hear all the time …

“I trade with a 2:1 reward-risk ratio and I win 50% of my trades.”

Hmmm. My filters are waving red flags.

Let’s say this genius has a £10k account and is trading 300 times a year and risking 2% per trade.

With simple compounding, they’d have £170k at the end of their first year of trading.

They’d make their first million in year two. And after six years, they’d be building space ships with Jeff Bezos.

Every trading strategy has expectancy or an edge – this is a measure of its success (or otherwise). I’ve talked a bit about expectancy elsewhere, and how to measure it.

But here I want to talk about your basic winning edge.

The winning edge is what tips the odds in your favour – your strategy that means your profits outstrip your losses and you ultimately come out on top.

Let’s go back to those claims around the 2:1 reward-risk strategy. To break even in this kind of system, you’d need to win around 34% of the time. They are claiming to win 50% of the time, which means they have a winning edge of 16%.

I’d love to tell you that a 16% winning edge was possible for traders, but it wouldn’t be true.

Here’s some context …

In a casino, playing blackjack, the house edge is around 0.5%. On the roulette wheel, it’s higher, at around 5%. The only place a casino could hope to get a 16% winning edge is on a slot machine.

Genuine, profitable trading strategies achieve an edge of between 1 and 5%.

Despite what we’re often told, trading is not a game that thrusts piles of gold into your lap. Instead, it’s a game of chip, chip, chipping, gaining ground inch by inch and reinvesting those winnings until the scale of the gains means you can start drawing an income.

I’m currently working on a brand-new trading strategy. I’m really embracing the reality of trend trading, which means accepting lots of small losses, to achieve the big wins when the market does make its move. This means my reward:risk is an impressive 5:2, so my average win is 2.5x bigger than my average loss. Trading with this kind of ratio means that you only need a 29% win rate to break even – i.e. you win 2 out of every 7 trades. At the moment, my new strategy is showing a win rate of 37%. This means my winning edge is 8%.

But before I get carried away, I need to remind myself that these are early days in my testing.

Which brings me to an important caveat …

If someone tells you they have a 1:1 risk-reward profile, and are winning 80% of their trades (i.e. they have a 30% winning edge) – they aren’t necessarily lying to you. They may just be using an unrealistically small sample size.

I’ve certainly had super-hot winning streaks when my winning edge has looked through the roof. I’m embarrassed to admit, that in these moments, I’ve sometimes extrapolated those winnings out, and wondered what it’ll be like living on the island next to Richard Branson.

But in the real world, I want to see a good number of trades, across a range of trading conditions. It’s hard to put a number on the number of trades, because if you’re trading longer term charts, it can be tough to build up hundreds of examples. But with shorter term trading, it’s easy to expect at least 200 trades.

The winning edge filter

Asking about the winning edge is a great way to filter out the genuine article in trading. (It doesn’t tell you everything – you should know about drawdowns, RRRs and win rates too.)

You’ll be amazed how often traders will go silent when questioned on this – either they don’t know their edge, or they are choosing to keep it quiet.

If you want to calculate it on your own trading, I’ve just updated the Trader’s Bulletin Trading Journal to include winning edge. (Until now, it’s just measured expectancy, which gives much the same information, but presented differently.)

You can download the latest Journal HERE.

I look forward to hearing what you think of it.

 

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