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Forex Trading Tips: The Paradox of Negative Edge
The Paradox of Negative Edge
The latest book I am reading, Fortunes Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone is a fascinating account of how some of the smartest scientific minds in America along with some of the most unsavory characters in organized crime managed to create a perfect betting formula that provided just the right balance of risk and reward in order to generate massive profits for those bettors who enjoyed an edge in the game.
The key to success however, lay in the ability of the bettor to garner an edge. Without it, the Kelly criterion as the formula is known cannot help you, despite its very clever math. The underlying thesis behind the Kelly criterion is to bet only a portion of your stake, ratcheting up the amount as you hit a winning streak and decreasing the bet size as you start to lose. By betting a smaller and smaller amount each time you lose, you avoid what’s known as gambler’s ruin – where you eventually run out of money.
The Kelly criterion is a brilliant piece of mathematical work, created by scientists responsible for the intellectual foundation for all of modern electronic technology. Literally every device we use to communicate with each other from the computer, to the cell phone, to the satellite is a direct result of these men’s inventions. The story of how the Kelley criterion came into being and generated millions of dollars for some of the earliest quant funds on Wall Street is fascinating tale of the intersection between Mafia, MIT and Bell labs and is worth reading just for its dramatic impact alone.
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However, this week I’d like to focus on just one aspect the Kelly formula – the idea of an edge. As traders we are constantly taught to seek out trading opportunities with a positive edge. Books are littered with advice to always look for trades with at least 2:1 reward to risk ratios (This way you only need to be correct just half of the time and you’ll make money! They cheerfully inform you). Some of the professional currency strategists I’ve encountered even boast that they never trade anything with less that 4:1 r/r ratio.
We have all heard the statement that 20% of your employees generate 80% of your output, 20% of your customers provide 80% of your revenue and so on and so on. In general this is true in markets as well. The Pareto distribution, as it is known scientifically is present in many types of observable physical and social phenomena including the financial markets. In theory, under the Pareto distribution a few good trades will make up the losses of many bad trades.
There is only one problem – human psychology. Suppose I gave you a choice. You can take 10 trades 9 of which would lose you $10,000 each or $90,000 in total and the tenth would make you $120,000 for a net profit of $30,000. Or you can take 10 trades where 7 would make you $20,000 each and 3 would lose you $40,000 each for a net profit of $20,000. On the surface the first strategy appears to make you more money but I can almost guarantee you that 99% of traders will wind up losers under that method. Why? Human beings hate to lose. Furthermore they hate to lose consistently. If you deconstruct the first strategy you basically have only 1 out 10 chances to make a winning trade. These are lottery like odds for an average trader. Here is what’s most likely to happen. You will quit after the third trade and never catch the winning trade in the sequence. You will cut your winning trade short because you are so desperate to recoup some – any – part of your money that the end result will still end up negative. Or worst of all you will miss the one winning trade and will simply generate 9 losers in your account.
Flip the scenarios. In strategy number two you have 7 out of 10 chances to win. That fact alone is likely to keep you on track and help you adhere to your trading strategy. Furthermore, if you are lucky you may even miss one of the large losers and improve your performance even more. That’s the paradox of negative edge. At BK we trade with a negative edge not because we think it is mathematically superior – we know that it is not. We trade with negative edge because we know that it is psychologically more palatable and trading at its core is always more psychological that it is logical. Academics never factor in human frailty as a variable and yet it is perhaps the most important element in achieving long term trading success.