In the previous post, I said that repeatedly executing a trading strategy with an edge is almost the only free lunch in trading.
So what exactly is a trading strategy with an edge? Let’s take a closer look. Once we do, it becomes clear why this is almost the only free lunch.
I’ll break down the trading strategy itself into a small series next time, so for now, let’s look at just two fundamental conditions.
The first condition for a trading strategy with an edge, as we already discussed, is that it must make money over the long run when repeated.
Take the Martingale strategy, for example. Keep doubling your bet whether you win or lose, and before a sufficiently long losing streak comes along, eventually there will be a happy moment when you make a huge amount of money. Then you just stop there and go home.
That’s how anyone can go broke.
Because the second condition is missing: the strategy must be able to survive over the long run. In theory, surviving a Martingale requires infinite capital. And if you have that much capital, you wouldn’t be reading this post anyway.
Martingale makes survival almost impossible by the very structure of the strategy itself.
But if we want to survive over the long run with a realistic trading setup, we have to talk about uncertainty in the market.
Whether you trade or invest, the biggest question for anyone participating in the market is always the uncertainty of the future.
You need to have some idea of what might happen next in order to decide how much to risk, make an entry plan, and know how long you can hold on.
So we constantly look for predictability.
No matter how much some trader says, “I don’t predict. I react,” that’s bullshit.
Reacting itself involves prediction. More precisely, it is conditional prediction.
If this scenario happens, I expect this to happen next, so I’ll react accordingly. If you go long without making any kind of prediction about whether the price will go up or down, that’s not trading. That’s pulling the lever on a slot machine.
Everyone predicts.
They just don’t prophesy.
So everyone seeks predictability.
Even the people who say, “One big shot! I only need it to work once!”, who probably aren’t reading this post anyway, are, when you look closely, obsessed with predictability more than anyone.
Those people are often the first to ask about the win rate when looking for a trading strategy.
90% win rate. 99%...
Being obsessed with the win rate is itself an attempt to seek predictability.
Whether that is the right kind of predictability is something we’ll get to later.
But there is an even more extreme example, and it is remarkably close to everyday life.
Insurance.
Insurance is, on average, a losing proposition for the buyer.
We pay an insurance premium and, in return, avoid potentially catastrophic losses that would be difficult to bear.
And yet we willingly buy fire insurance, car insurance, health insurance.
Why?
Because we are willing to pay the premium, even knowing that we will lose money on average, to protect ourselves from extreme events that we simply cannot afford to absorb.
In other words, we want protection from the so-called Black Swan: a destructive event that falls far outside our expectations or calculations.
Insurance is, quite literally, paying a price to pull the trajectory of our lives back inside the boundaries of what we consider predictable.
There are Black Swans in the market, too.
There have already been several massive drops this year, and I experienced the collapse of my discretionary trading firsthand during one of them. (And that is what eventually led me to start systematic trading...)
A trading strategy with no protection against such extreme events cannot guarantee long-term survival, and therefore cannot be considered a strategy with an edge.
For example, a full-size strategy with no stop-loss is not a strategy with an edge.
“But I made huge money without a stop-loss.”
Sure. You can find someone who hit the jackpot on a slot machine too. The proportion is no different.
A trading strategy with an edge is one that both makes money when repeated over the long run and provides a structure for long-term survival.
Remove either one, and repeated execution will eventually lead to an empty account.
That is why repeatedly executing a trading strategy with an edge is almost the only free lunch.
“Almost” simply means it isn’t 100%.
So, let’s say you’ve found a trading strategy with an edge.
Does that mean that you could earn money if you simply repeat it blindly?
The answer is, “Eventually,” yes.
At least, if you’re satisfied with nothing more than a free lunch.
But suppose that strategy gives you 100% PnL while producing a 70% MDD.
Something seems quite wrong with that.
Or suppose it gives you 100% PnL, but makes nothing for three years and then delivers all the profit in the final two days.
Something seems wrong with that, too.
Don’t you feel that little urge creeping in to “adapt flexibly” and fine-tune the strategy?
In the next post, I’ll talk about the Trading Triangle and the Strategy Triangle I propose, and what “being flexible” actually means in the context of probabilistic thinking.
Because the kind of “flexibility” usually preached by fake gurus is, in one word, bullshit.
This article is educational content about trading and does not constitute investment advice or a recommendation to trade any specific instrument or strategy.