On quiet Friday it is always worth reflecting a bit on the bigger issues in trading and investing. Today we are going to demonstrate why luck, or randomness if you will, is so important for even successful traders with a statistically significant edge. Our experiment will show why the market cleverly roots out the weak and ensures few will survive on a systematic approach.
What type of edge is required to be successful?
It all starts with a strategy, whether it is systematic or discretionary, which requires a positive edge. This is the fundamental foundation of speculation. No positive edge leads to loss of capital over time. But besides an edge, traders need good luck, but we will come back to that shortly. Let us start an experiment to build our chain of logic.
Let us assume that we have found a systematic approach (it could be some combination of technical indicators) that generates an expected win ratio of 53% by daily trading the 10 largest commodities futures. This is a pretty good edge on daily trading strategy in for the most part non-trending instruments. We sample with replacement 1,260 return observations (four years of trading) for each commodity based on its price history. We do this 1,000 times it generates many hypothetical paths our strategy. Based on these synthetic trading decisions we can create an equal-weight portfolio with total returns adjusted for roll-yield and trading costs (only commission and bid-ask spread, as we assume no price impact on trades). The plot below shows the distribution of annualized returns for this strategy over its 1,000 paths. The average annualized return is 19.7% which would take this trader into the premier league of trading.