I have a simple idea about so called edge deterioration, I will try to explain it in this post. It's understood that trading edges deteriorate over longer run. This is said to happen due to the fact that too much trading capital is thrown to exploit the edge (i.e. too many people start to spot and use that edge). Then the market changes (adapts), it's said it becomes "more efficient" and the edge is no longer profitable. Here's a simple thought experiment: if edge becomes unprofitable, people exploiting it start losing money and abandon that edge (or lose everything), right? So what we get is the process where less and less trading capital is thrown to exploit the edge - an opposite of what was described in above paragraph. Following this logic, the unexploited edge should become profitable again. Is this true? Does this "edge cycle" exist in the markets?
Yes i think it is important to try to understand how potent an edge is now versus its use in the past... so Is the Edge fading / failing like many edges do (when others discover it and exploit it) - is the edge increasing in value or staying constant... <blockquote> If the Edge is 'new' in time and you can also discern a slight increase in its effectiveness then your position sizing could also be increased (rationally) along with it... If the Edge is 'mature' in time then your use of it and your position sizing could be deployed consistently with extra care taken to watch for outlier / exception events... If the Edge is 'old' in time (others have discovered it - market rules are dimming its effectiveness) then reducing onces position size could be an important consideration... If the Edge is 'fading / failing' then no position size may be best and monitoring from paper only may be prudent until it can be quantified that the edge has returned... </blockquote> As well as considering the idea of FADING the old edge as a new edge although that would need to be tested... too... Everything has a life cycle... especially in the markets where lifecycle's seem to peak faster than in other arenas... So where in the life cycle an edge is could be important to your long term P/L... <img src="http://www.enflow.com/p.gif">
i think edges deplete to the point of breakeven transaction costs most of the time. it's really rare to see an edge flat out reverse into a sort of negative expectancy situation over the longer haul - ie once you've stopped trading it
Two thoughts... There will always be new people entering the market and using old data that shows the edge. Their hammering away at it will keep it from re-emerging. It's like reprocessing old mine tailings. There is just enough left there to keep people fascinated and hooked. As the edge degrades, the most efficient traders, those willing to operate on a small return, will stay with it and keep the market efficient. For example, there are organizations still doing index arbitrage even though the markets are too efficient for most of us to make a business of it. [rwk]
Basically to stay consistent in profits, you should have a few edges at once and the money management scheme should apply risk weights among your active edges. Like immune system, you could periodically readjust weights, so less is risked on deteriorating edges, and more on healthy ones. The two things you should decide here is: 1) how often you should readjust the weights (for example, 3 months), and 2) how far into the past results you should look to determine if edge is deteriorating or not (for example, last 2 or 3 years).
One more thought.... "There's no such thing as an edge"... well, at least not a legal one. You see, when Bernanke talked to Paulson and he gave "the wink" to Da Boyz at GS, THAT was an edge.
Excellent Commentary I have a simple idea about so called edge deterioration, I will try to explain it in this post. It's understood that trading edges deteriorate over longer run. This is said to happen due to the fact that too much trading capital is thrown to exploit the edge (i.e. too many people start to spot and use that edge). Then the market changes (adapts), it's said it becomes "more efficient" and the edge is no longer profitable. Here's a simple thought experiment: if edge becomes unprofitable, people exploiting it start losing money and abandon that edge (or lose everything), right? So what we get is the process where less and less trading capital is thrown to exploit the edge - an opposite of what was described in above paragraph. Following this logic, the unexploited edge should become profitable again. Is this true? Does this "edge cycle" exist in the markets? .................................................................................................... This is interesting particularly when one considers the election by committee for the larger money pools such as corporate retirement funds... In fact groups that monitor money managers usually divide them by money management style... And often is the case that a particular style of active management will lag or underperform other styles. It is the job of the administrator to oversee the money managers and see that they adhere to their style of management...even though it may be currently out of favor... Some years ie contrarian large cap may outperform other styles ie convertible based market neutral etc...and ie indexing may outperform some other style in some given years etc.. What the administrator wants to see is consistency in the applied style...because that is what was elected... Thus edges in regards to these forms of money management definitely come and go... in and out favor from time to time...
Mid-Cap DAX, huh? That's fine. It's OK, you don't have to educate me about edge. I used to have one (lots of others had it too) and it was legal... but the revenooers took it away. And while I'd LIKE to have an edge (who wouldn't), I don't need it to make my piddly sums.