Probability is important but
probability without understanding risk-reward
ratio means nothing because together they
constitute your edge.

For instance there is no
point having a strategy that wins 95% and results in
a profit
of $10 or a loss of $1000. Why?
Because if you make 100 trades then even though
hypothetically 95 of them could be winners 95 X
10 = $950, losing just 5 trades would result in
losses of $5000 and an overall net loss position
of $4050.

This is why its not so much
about how often you are right in terms of your
trades but more important in understanding what
is the relationship of the risk-reward ratio to
your probability of success and ensuring you
have a positive expectancy (known as an edge).

**MY PRIMITIVE PROCESS OF
FINDING AN EDGE**

When I started out looking to
develop a trading strategy I started out with about
10-12 hypotheses based on a theoretical
understanding of how I believe the markets of
interest would
react given certain circumstances in a football
match. I had to identify particular variables
which I felt were important in contributing or
preventing the market validating the hypotheses. This
allowed me to then generate a percentage as to
how many times I was wrong vs how many times I
was right in terms of my hypothesis about how
market would react with
specific scenarios from the past.

I also would have needed to
have known what were the market prices at the times I
would have taken the trades and what would have
been my exit point from the trade as this would
enable me to determine what my risk would have been and
what my profit margin would have been.

So using a combination of
probability of successful trade and
understanding what my risk-reward ratio was I
then was able to conclude that after back
testing over 100 trades for each hypothesis, 9
of the hypotheses were unprofitable and 3 were
profitable. For the 3 that were left I then went
to work in running
another simulation of 100 trades and then
another until I had data from over 500 trades.
If they still remained profitable over the 500
trades then I knew I had something. After a
further 500 trades only 1 hypothesis remained
profitable.

Now it was time for
optimization
and seeing if there were any additional filters I
needed to apply to help streamline the process
and net profitability, whilst not being sucked into
what is known as curve fitting.
Optimization could be based on other factors such as did
I notice that my strategy had a higher
percentage of wins when I focused on football
matches in specific countries. For instance
there are countries which have a historical
reputation for not scoring lots of goals like
Belarus whereas there are other leagues like in
Holland where they are known for playing an
attacking brand of football. Armed with such
external information could then help me to make
decisions that helped in the optimization
process.

Once I was happy with the back
testing performance the next stage was to trade
using a demo account and run this strategy for
500 trades. If the results at a minimum affirmed
the same level of performance from the back test
then it was a positive sign to continue so the
next step would be to test it in a live
environment using very small stakes. Once I was
able to demonstrate that the strategy worked in
a live environment with small stakes then this would mean I now
had the confidence to scale up my position size.

This is a high level overview
of how I look to identify an edge. Obviously
there is a lot more detail which goes into
the realms of statistical analysis, standard
deviations and different measures of volatility
but I am trying to keep this very high level.

Edge simply means a strategy
that gives you a higher probability of creating
net profit over the long term rather than having
net loss. Its not just about the percentage of
wins but also about the percentage of wins
coupled with your risk reward ratio. This is
something which works well especially if you are
working with a strategic model that employs
defined risk.

Its all about coming up with
a number of assumptions or hypotheses about the
market you are in and then using data analysis
to either prove or disapprove your assertions.
But it does take time. The back testing process
took me about 3-4 months, the demo account took
me 1 month and the small position sizing stage
took another 2 months before I was ready to ramp
up my position sizing.

This means that unless you
are someone who has access to simulations that can
run thousands of back testing trades in a short
space of time, the process of finding an edge
could be a lengthy one. But its worth the
experience compared to trying someone else's
strategy because there is more fulfilment
creating something from your own intuition.

**RISK AND REWARD**

Now that we have got the
basics out of the way in regards to identifying
an edge here is a very important component for
your consideration.

My primary trading strategy
is built on what is called 2.75R. This means the
ratio of risk to reward is as close to 1:2.75 as
possible so I seek trading
opportunities where my profit is over two and
half times the size
of my liability. In seeking these opportunities
my weekly win rate averages around 50% and I
normally place around 30 trades per week.

Notice that experienced
forex traders like Charlie Burton trade with a win
rate of 50-60% and a risk-reward where their
winning trades are at least twice the size of
their losing trades. Many of the world's best
trend following systems in financial markets
have win rates of less than 40% yet make
considerable profits. There is something about
trading counter-intuitive (going against the
need for an excessively high win rate) which
seems to reward you much better over time
providing you have the right psychology to
embrace it.

Ultimately you neither need
an extremely high win rate nor a large
reward risk ratio to make money as a trader. As
long as your reward risk ratio and your
historical win rate match, your trading will
provide a positive expectancy. This is why you have to test
things out for yourself to find the right
balance between win rate and risk reward ratio
because this is the building block of your edge.

In conclusion, your trading
edge is your bedrock. It is the granite that
holds your trading strategy together in adverse
conditions when the market gods of destruction
seek to shake the exchange you are trading on so
that those who have no firm foundation drop off
like rain falling from the sky. You cannot be a
successful trader without an edge. If you have
no edge then I am unsure as to how long you can
survive.

When you know your edge then
trading becomes like a board game. Its all about
the numbers. You no longer have to worry about
losses because you know its about profiting over
a series of trades as opposed to getting
emotionally sabotaged by single individual
trades.

Finally, its important to
realize that you need to trade with enough
frequency for your probabilities to play out and
this becomes clear when you understand the law
of occurrences (large numbers) and the law of
streaks.