Is Edge Multiplicity for Real?

Here is a talk between two market wizards, Mark Minervini and David Ryan. If you have not listened to it already, I recommend you to listen to it at earliest. You will probably thank me later.

One thing that caught my mind in this talk were Mark’s words, “Try to stack up probabilities/edges in your favour in every trade you make. This way it is not addition, it is multiplication of edges!”. Now many of you might ask, there is only one probability i.e. win rate or probability of being right in the market while trading the market actively. What other thing are you talking about?

Ok, at some level I agree but I also agree to disagree with this statement. Here are some of that probabilities in my opinion that stacked together with your existing edge may do wonder:

  • Selling option on the direction of trend (edge here is theta decay)
  • Best edge out there is timing the market. like if doing Intraday trade then not to trade trade between 11 p.m to 1 p.m as this time the overall market remains choppy. But it is a very subjective interpretation.
  • Eliminating risk of ruin by hedging overnight position.
  • Buying the Fear and Selling the Greed- I have discussed this in detail here.
  • Treating investment as long term trading i.e. putting initial stop-loss and trailing the profits on the upside.
  • Keeping overall account equity curve smooth by trading uncorrelated strategies.

In this post, we will examine the result of stacking up various probability in a simple model that is applied on our favorite(at least mine) index ‘BANKNIFTY’.

We will begin with this question, “What is BANKNIFTY’s reaction after it breaks Previous day High or Low?”.

Below chart shows the result of going long after previous day high(PDH) and going short after previous day Low(PDL) is broken and closing trade at 3:29 p.m. Time Frame used here is 1 minute.

Our idea proved to be a disaster almost every year. After digging into some of the trades in backtest result, I understood there are three main reasons for this:

  • When BANKNIFTY opens a gap up/down above/below PDH/PDL and then reverses immediately making our initial hypothesis wrong by a large extent!
  • We are considering 1-minute data so there can be many false breakout-down.
  • No SL in-place to close losing tarde at a small loss.

So, in order to avoid drastic effect of above causes, after giving it lot of thoughts, I came across below setup,

  • Instrument: BankNifty SPOT
  • Time-frame: 5-minute
  • Entry Time: after 9:40 and before 2:00 pm no entry allowed outside this timeframe
  • Rule 1: After PDH/PDL is broken wait for strong action i.e. candle that have 80% body and 20% wick, go long at close of such green candle if PDH is broken and short at close of red candle if PDL is broken.
  • Rule 2: Stop-loss is 0.5% of entry price on either side.
  • Rule 3: if Stop-loss doesn’t get hit, close the trade at 3:20 p.m.

As we can see in the above chart the result improved very much after adding a new constraint. So, What Mark was talking about multiplication of edges not addition is proven to be true.

Still one can argue that the total points captured in this 5 years is not convincing. This is not a good setup to trade. Yes, I agree with this argument but one can further improvize it by adding SL to the initial idea. And instead considering the future, selling slightly out of the money weekly option whenever a signal is generated will give more edge to the system.

As we have seen “Stacking up probabilities/edges” really do wonder for the trader. I would like to conclude this post by quote by Ray dalio,

Raising the Probability of being right is valuable no matter what your probability of being right already is – Ray Dalio

Happy Trading until then!

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Kevin Kukadiya

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