How do you answer when someone asks you "What is your edge"?

You’re interviewing for a trading job and are sitting in a conference room across from the head of trading at a major investment bank. Everything is going smoothly and you think you’ve made a good impression so far. Then he throws you a curve ball. “What is your trading edge?” he asks.

It’s a question that many traders struggle to answer. After all, us discretionary traders are all looking at the same charts, reading the same analysis, and reacting to the same news as everyone else. Unless you are a high frequency trading firm with colocated servers next to the exchange or a stat-arb quant fund that can crunch petabytes of data to find statistical patterns in price, you can’t point your finger at any type of edge in particular.

Or can you? Just because you don’t have a structural edge in speed, computing, or information doesn’t mean you don’t have an edge at all. Trading edge comes in many shapes and sizes, and if you can identify that “X-factor” that makes you profitable, then you can focus on honing that skill and using it to identify high conviction trades.

In this post, I identify the different types of edge I have in my toolkit or have seen/heard other traders use.

Time horizon arbitrage

Time horizon arbitrage is when you take advantage of the fact that the market is moving in reaction to something that sounds like a big deal right now, but will fade into the back of the market’s consciousness over the course of the next few hours/days. For example, there was a phenomenon during the major USD bull trend last year when a central bank like the European Central Bank or the Reserve Bank of Australia would hike rates or be more hawkish than expected and EUR or AUD would rally against USD. However, the USD uptrend was so strong due to the Fed’s determination to fight inflation and the market’s focus on US data (which was strong) that within 24 hours, the post-central bank move had reversed, and EUR or AUD would often end up lower than where it started before the event. Those with a longer time horizon were looking beyond that central bank meeting and using the strength in EUR/USD and AUD/USD to enter shorts.

The market effect of economic data and other events can mean revert more often than not. One driver of mean reversion is that those traders who bought or sold on the event eventually have to square their positions once they believe the event has been priced in. The last traders to cover their positions often find themselves chasing the market as it reverses back towards their entry level (or past it). Traders who understand the dynamics of time horizon arbitrage will better navigate the seemingly arbitrary whips and turns of the market.

The other reason is that the market can only focus on 2-3 themes at any given point. Last year the market spent most of its time focusing on US economic data and the Fed. If the market moved on anything outside of those two things, the move would usually mean revert as the market refocused its attention back towards US interest rate expectations. This brings me to the next edge.

Superior interpretation of market events - understanding the language of the market and second/third order effects

As a trader, it’s always important to know what are the 2-3 themes your market is focusing on right now, because then you are better equipped to act (or not act) on new information. It’s also important to know how to parse through central bank language and political headlines to figure out what is important and what is not. The same goes for interpreting economic data - trading on the headline number vs digging into the components of the data. The first order effects of market events are always apparent, and that’s what the market trades on. SVB going under was clearly negative for equities. The second order effect was that depositors lost confidence in regional banks in general - also risk off. The third order effect was that the Fed had to create new facilities to provide liquidity to the banking system, resulting in a spike in USD liquidity that supported equity prices for over a month. The experienced trader who understood how this chain of events would unfold had a clear advantage over the average Joe watching CNBC.

Understanding market structure and positioning and knowing when actors are being forced to trade vs trading on fundamentals

Great traders know the different actors in their markets - how they behave, how they are positioned, what is their time horizon, and what is the volume and market impact of their transactions. In FX, the market participants are wide and varied, from hedge funds, quants, asset managers, corporates, to retail traders. In a smaller market like soft commodity futures, the actors might just be commodities trading houses, a handful of funds, and trend following strategies.

The part that gets interesting is when you know a certain segment of the market is positioned heavily in one direction, making it likely that a market reversal would force them to cover their positions in a volatile matter. Often this lopsided positioning comes with leverage that forces them to unwind when the market moves against them. One example was Japanese retail traders (nicknamed Mrs. Watanabe) who held large carry trades where they were long high-yielding currencies and short the Japanese yen on leverage. For a long time, they benefited from both the interest income from the positions and the market drifting in their favor over years. However, the risk-off moves during the GFC triggered a cascade of liquidations of carry trades, and the yen would violently strengthen on those days. As an FX trader it was common to see 2-5% moves in the yen markets in a day. Understanding this dynamic gave me an edge during 2008 and contributed to a standout performance that year.

Exploiting euphoric and fearful markets

Bubbles and crashes are a common occurrence in the markets. They can sweep up entire asset classes (like crypto in 2017 and 2021) or occur in small pockets of the market (there are always single name stocks exhibiting bubbles and crashes at any given time). It is difficult for the average market participant to know when a bubble is in progress or unwinding, and this is where experienced traders get their edge. Experienced traders understand how narratives and hype can create a bubble, how sentiment and upside volatility can expand at its peak, and how to spot a bursting bubble and its imminent collapse from its price action. Bubbles can be lucrative to trade because those who get in early to mid-trend benefit from the upside volatility, while those who bet on the collapse can profit from sharp moves within a short space of time.

To be continued in Part 2…