What is Edge Erosion in Stock Trading?

What is an Edge?

You probably have heard the term "edge" when used by a person referring to a specific activity, competition, or profession at least once before. This could have occurred in the context of trading stocks or options, playing golf, or even a trivia competition when covering a specific subject or topic.

To obtain an edge, an individual must possess knowledge around a specific subject, topic, or skill, which is then translated into the creation and successful execution of a strategy surrounding that knowledge to have an advantage repeatedly and statistically over their peers within the same context. Simply put, an edge is a strategic advantage you have that someone else does not.

For instance, if a golf tournament were to occur during a day where heavy winds were present, the golfer who has repeatedly practiced and is comfortable playing in windy conditions would have an edge over their counterpart that has not consistently played in such conditions. Translating that into stock trading and options trading, an edge would refer to a trader with deep knowledge and understanding of one or a handful of trading strategies in which the trader is comfortable, confident, and has more times than not been statistically profitable executing said trading strategy.

What is Edge Erosion?

Edge erosion in the context of stock trading and options trading would be the breakdown or erosion of a consistently used, profitable, and relied upon trading strategy due to changing market conditions, shifting behavioral tendencies by the trader, or the sudden emergence of an inability by the trader to successfully identify preferred trading setups to appropriately execute their trading strategy at the consistency they did before edge erosion began to occur.

For simplification purposes, we'll relay this back to golf. Edge erosion in the context of golf could occur if a golfer has a specific strength on the course that then begins to falter. For instance, if a golfer frequently practices putting inside of ten feet and is statistically efficient at doing so for long periods of time, but then begins to decline in performance in this area due to changing weather conditions, psychological barriers such as stress or performance anxiety, or shifting pin locations, then you could consider edge erosion to have occurred. 

Dangers of Edge Erosion

The dangers of edge erosion are readily apparent, especially if the field in which you have an edge in, involves the wagering of, use of, or risking of capital. In this context, when your edge begins to erode, so does your capital. In the context of trading stocks and trading options, the emergence of edge erosion would likely lead to less equity in your brokerage account i.e. the loss of capital. Edge erosion could also lead to shaken confidence which could then cause a spiral effect on the trader of sorts. The psychological effects on a stock trader or options trader experiencing edge erosion could be troublesome if your psyche isn't fortified and you don't have an extensive "toolbox" to divert to alternative trading strategies. Imagine if you were consistently identifying setups on trades, properly executing your trading strategies around these setups, and making consistent profits over extended periods of time and then suddenly, these same setups and trading strategies no longer worked on a consistent basis, and you are now losing capital because of it. This could greatly affect your psyche surrounding trading stocks and trading options and could potentially put you at risk of giving up trading altogether.

How to Combat Edge Erosion?

Notice that we didn't ask how to avoid edge erosion. This is because all of us will eventually struggle with an area, discipline, or activity, that we feel we have a firm grasp on and/or a competitive advantage i.e. an edge, whether for a short period of time or a long period of time. The real question stock traders and option traders should ask themselves is "When I begin to encounter edge erosion, how do I combat it?". This is where the true journey to self-growth begins.

There are two key steps in successfully combatting against edge erosion in stock trading and options trading. One is psychological, and the other being skill and knowledge. The psychological aspect must come first before implementing the skill and knowledge aspect.

1) Quickly identify that edge erosion is occurring.

The faster that you as the stock trader or options trader can identify that edge erosion is occurring, the faster you can pivot to step two. A barrier with any individual who has an edge in a specific sector, or activity is the development of confidence that can border on arrogance and/or pride. This can cause you as the stock trader or options trader to lack introspection, be less honest with yourself about the "why" in terms of a noticeable decrease in performance and trade quality, as well as cause you to look at situations less objectively because you view yourself as an "expert" on the strategy you've developed an edge executing for extended periods of time. The faster that you can identify that edge erosion is occurring, be honest with yourself about it, and pivot to another strategy you feel knowledgeable and comfortable executing, the faster you can attempt to put yourself back on the right path.

Just as we have done throughout, let's compare this to golf. If you have developed the ability to be extremely efficient with your driver in terms of hitting fairways off the tee box more than 50% or 60% of the time, it's statistically the strongest aspect of your golf game, and you are more skilled than your peers at it, then using your driver is your edge when playing golf. Now, let's say on this day, the fairways are narrower than most courses and conditions are windier than most days. External conditions are not properly setup for you to efficiently apply your edge for that specific round of golf. Therefore, it would be wise to divert to a "Plan B" that you have practiced and feel comfortable with for conditions like these, such as hitting a low iron off the tee box instead. The faster you come to this realization, and pivot your strategy, the likelihood is that your score will be lower that day. Inversely, if you only feel comfortable using a driver off the tee box, and this is your sole edge in the game of golf, or if you refuse to recognize that your edge would be eroded that day due to external conditions and pivot to your alternative strategy, then your score would probably be higher. This is the importance of identifying your edge is eroding or has eroded and it's an appropriate time for you to pivot to an alternative strategy.

2) Develop an extensive toolbox of trading strategies.

Now that we know the correct perspective isn't to avoid edge erosion, but rather to combat it, the only way to do so (after identifying edge erosion is occurring), is to continuously seek out new information to develop a "toolbox" of strategies for varying market conditions, trading setups, and other ever-changing external conditions. If you as a stock trader or options trader were able to develop a wide array of trading strategies, each of which worked in differing market conditions, macroeconomic environments, times of day, sides of the market (long and short), etc., then you would have developed and sharpened a diverse range of skills, perspectives, and strategies that could then give you a more holistic edge that isn't reliant upon just one setup and strategy. This would help to aid in the extension of your stock trading or option trading career, give you increased confidence that you could thrive in varying market conditions and confidence in executing many different strategies, as well as make you a more well-rounded, knowledgeable, and holistic stock trader or options trader.

Relaying this example back to golf, recall the example we used with the golfer who's most effective aspect of their game is using their driver. Imagine if they also practiced in windy conditions with their driver, or they practiced using low irons off the tee. This would give them multiple "edges" in their game, which should increase the chances they keep their score low regardless of the course structure or weather conditions. Developing this toolbox of skills in their golf game would give them increased confidence before they ever stepped foot on the course that they can succeed regardless of the external environment. It also, gives the golfer the ability to choose from a toolbox of strategies to score as low as possible. Relay this back to stock trading and options trading, you can see that developing a diversified strategy toolbox to use in varying external environments can help to prolong your stock trading and options trading career, give you increased confidence to succeed regardless of external factors, and make you a more holistically sound individual.

Conclusion

In conclusion, an edge is an advantage you have that most others do not regarding a specific subject, sport, topic, or profession. Edge erosion is the breakdown or faltering of that edge due to external factors, psychological barriers, and ever-changing market conditions. Edge erosion in the context of stock trading and options trading can cause shaken confidence, stress, self-doubt, and the loss of capital. Rather than avoid edge erosion altogether, which isn't possible as external environments and macroeconomic conditions are constantly changing, the appropriate perspective is to ask yourself "How do I combat edge erosion?". There are two ways to combat edge erosion. The first being the ability to identify that edge erosion is occurring and making the decision to pivot to an alternative strategy. The second aspect to combatting edge erosion to continually learn new methods and trading strategies surrounding stock trading and options trading to develop an extensive toolbox of trading strategies you can utilize across differing market conditions, macroeconomic environments, times of day, sides of the market (long and short), etc. Viewing edge erosion in this light should help drive you to constantly take in new information to expand your toolkit and to aid in the extension of your stock trading and options trading career.