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Forex Trading Strategies: An Edge is Not a Win
An Edge is Not a Win
I can bankrupt you in five easy trades with a setup that’s 95% accurate. Suppose I gave you a trading strategy that wins 95 times out of a 100 with an even 1:1 risk/reward ratio. Most traders would give up their right arm for such an edge. But watch how quickly things can go wrong. If you trade with 10:1 leverage and risk 2% on each trade (20% levered) 5 consecutive losers – which are well within the statistical realm of possibility – will wipe out your whole account.
But statistics and leverage are not the only problems we face as traders. The whole notion of an “edge” should be taken with a barrel of salt because trading is a social, rather than a hard science and any conclusions that we draw from our research into price behavior are therefore highly suspect. Allow me to elaborate. One of the great advantages of hard sciences like physics or chemistry is that we can replicate their experiments one million times in a row and achieve the same result.
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When Galileo dropped two unequal balls from the Leaning Tower of Pisa and observed that they hit the ground at the same time, he was able to refute 2000 years of Aristotelian logic. Furthermore, if each one of us chose to repeat the experiment we would arrive at the same results over and over and over again. That’s because in our universe, the laws of gravity remain constant allowing us to draw the proper cause and effect conclusions that we can extrapolate to the world at large.
Let’s move on to medicine where double blind tests on human subjects will often yield good but hardly universally positive results. Why doesn’t medicine work equally well on all of us? Because every human being is genetically unique (twins excluded) and the variations in our personal biology and anatomy make it impossible for scientists to keep all other conditions constant and replicate the experiment with 100% accuracy. When we perform a clinical trial we can safely conclude that this particular drug has been effective on these particular individuals and we assign some probability (50%, 60%, 80%) that it will be efficacious on the population as a whole. Generally, those conclusions are accurate, but as anyone who finds himself allergic to penicillin or immune to a particular therapy knows, medical treatments are far from uniformly effective.
Now let’s take a look at trading which is in essence a social activity and can therefore be studied as a behavioral science. Anyone with a teenage daughter at home can attest that consistency is not the hallmark of human behavior. In fact if we were to be honest with ourselves our own behavior is hardly a bastion of stability. Very often we will react in polar opposite ways to the same set of stimuli depending on our mood. The markets are of course the same way. That why any strategies based on historical price patterns which are in fact strategies based on human behavior should not be trusted fully. Mark Twain once said that history does not repeat itself but it rhymes. Alas, the variations in those rhymes can turn a profit into a loss. In a recent interview Jack Schwager noted that irrespective of the whether we are fundamentalists or technicians as traders well all trade patterns. Ultimately that’s all we can do given the nature of this game. However, no matter how much we love our setups we should never assume that they will last in perpetuity and we should never forget that an edge is not a win.