Line Your Own Pockets

Michael: 00:00

Alright, everyone. Welcome back to another episode of Line Your Own Pockets. Today, we're gonna talk about edge erosion. So it's probably something we should define a little bit first just to get into into the nitty gritty. But, for you guys, you're just hearing this week to week, but it's actually been a couple weeks since I've seen Dave.

Michael: 00:16

So I'm gonna take a second to ask. How how are you doing? How's it been, what, like, two weeks now?

Dave: 00:21

Good. Yeah.

Michael: 00:21

That's a long time without Dave.

Dave: 00:25

Yeah. It feels it feels like the the first minute or two, we're gonna, get some rust off. But, yeah, I'm glad to be back. This is, it's a fun topic, I think.

Michael: 00:35

Absolutely. So I'm gonna define what I kinda look at as edge erosion, and you can kinda correct me to see if you see. Part of the problem with our industry that I notice a lot is everyone can call whatever they want whatever they want. There's no, like you know, and and you would assume in medicine that there's standardized terms, and we we try to kinda make it up as it goes, but I think a little bit of, definition definitely helps. So for me, when I hear Igerozian, I just think, you know, take a strategy.

Michael: 01:02

Maybe you've backtested this strategy for twenty years. And in the first ten years, it was just making money hand over fist. And then in the next five years, it was still doing okay, but just not as well. And then the next five years, made a little bit less. And so you can kinda see over time as you're as you're testing or trading this strategy, there's just a little bit less money in it for you all the time.

Michael: 01:23

Is that did I hit the nail on the head there, or am I a little bit off?

Dave: 01:27

I think that's right. Or that's the way I think about it. It's interesting because the context in you in which you hear this talked about, it's usually much more sudden than that. And there's, like, this pants on fire emergency where, gosh, all of a sudden, the strategy that's worked so long all of a sudden, it stopped working.

Michael: 01:48

Mhmm.

Dave: 01:48

And it's erosion. You know? There's something out of my control that I can't, that I have no control over, and this strategy is done with. So but it's usually not the the case. And that that's kind of the problem I have with the the the discussion around this.

Michael: 02:06

Mhmm.

Dave: 02:06

It's like it's usually a sky like, the sky is falling. It's an emergency. But, you know, the longer you've been in the industry, the longer you've traded, the more you realize that these things happen all the time, and it's this is nothing new.

Michael: 02:25

Well and I've again, it could be different for my time frame and and what I do. I've always looked at it that if the strategy stops working all of a sudden, it's usually pretty normal. That I I I believe anyway that I'm in a pretty normal drawdown or or there's just something going on with the market that's not jiving with the strategy. I'd like your feedback on this. I've always just noticed that if it's true edge erosion, it's usually a little bit slower than that.

Michael: 02:48

It's it's and because the way I look at it is there's two things that can cause, you know, a lot of edge erosion. And one is you have an edge, everyone else starts hopping on board. Right? And that's that edge starts kinda degrading over time. That's kind of the more slower style of things.

Michael: 03:05

Then the other is just a pure some sort of fundamental market shift in in the way the market's trading or or even a regulatory or technology or or something like that. That's to me, I can't think of another reason why a strategy would go from working on Monday to to not working at all on Tuesday. I think that has to be one of those two things that that's kinda pulling away your edge.

Dave: 03:28

Yeah. I I have had a strategy that literally stopped working overnight. It was a great strategy. But it it was due to a structure change in the way the, the markets operated. So this edge just literally went away overnight because of a rule change.

Dave: 03:52

But other that's an unusual situation.

Michael: 03:55

Mhmm.

Dave: 03:56

Most of the time, it is gradual. There's not a particular thing you can put your finger on. There's not even a particular metric you can look at in the back test to determine, yes, this is eroded beyond the point where I can continue trading it. So that's kind of the hard part, but, you know, that that you're never gonna be able to look at this and and, like, get create a metric for yourself that says green is go, red is not go, and then stop trading it. So that that's really the hard part.

Michael: 04:32

Well, I I would say just in general, like, for systematic traders is trying to figure out, when to, you know, push the gas on a strategy, when to when to pull the brakes, and and when to pull the plug entirely. And, you know, so I think you got you got two options if you notice that that's happening. And one is to try to fix it, and the other is to move on to different strategies. So I think I already know your answer, but which one do you do and in in what order? Is it one of those you see that the edge is is lessened or or gone or or maybe just not even particularly gone and it's gonna start losing money, but maybe not worth your buying power at the time.

Michael: 05:12

Is it Yeah. Shelved while you fix it? Is it fixed right away? Is it, you know, something that you're doing? Maybe you're, allocating a little bit less risk or buying power to it, or or how do you generally approach it?

Dave: 05:26

So to to step back a bit here, I I think edge erosion is a real thing, and it's actually an inevitable thing. But it's way slower happening than you see people talk about and, you know, complain about. So, you know, if you do backtesting for long periods of time with lots of trades with some edges, you can see how, in general, you get a steep curve that levels off slower and slower and slower over time. And that's just the way things operate. I think in general, you know, more and more people notice the edge.

Dave: 06:13

Maybe they're on the edge. They trade the edge of the edge, so to speak, and there's just more and more people that learn over time. The market learns over time, and it it just smooths out that curve. So what do you do about it? I think, fundamentally, that is the job of a trader is to handle that exact situation well.

Dave: 06:41

It's it's relatively easy to find an edge, trade it for successfully for some period of time.

Michael: 06:48

Yeah.

Dave: 06:49

But what you'll run into is you'll run into edge erosion over time. And the one the traders that stay around and do well for a long period of time have the ability to adapt to that situation, and you're gonna have to. So the way I approach it, before I go live with a strategy, I will have what I call a road map for the strategy. So I've, you know, determined my rules for the strategy. I have determined, you know, what I think is optimal based on the buying power I have, based on the, the room I have, to to trade it.

Michael: 07:31

Mhmm.

Dave: 07:32

And I'll go beyond that. So I will create a couple additional rules that I sort of hold to the side, keep in my back pocket. And that way, you you when it when a strategy does start to erode a bit, you already have done the research to to know what to do at that point. And if you plan ahead and and prepare for that, it's a much easier situation to be in. So it's you're not in a situation where the sky is falling and your, you know, strategy is not, you know, all of a sudden not working.

Dave: 08:08

You you've got some you've got a plan in place that you can that you've researched and you've planned ahead for. So it's a much less stressful situation.

Michael: 08:21

Yeah. And that's I like that. Right, you're already saying, okay. When this breaks, this is here my here's my game plan going forward. I guess that kind of assumes that that's going to work, though.

Michael: 08:33

Right? So, you know, say say the strategy that just completely said wiped away overnight, Rarely is that going to, I think, happen where, you know, day one, it works. Day two, it doesn't. But if you get to a point where this road map that you've done, you start going down the road map of these are the things that I'm planning on doing to to do that, What if none of that works? Right?

Michael: 08:56

So, like, I'm just I I guess I'm trying to fish out when is the kill switch? Like, when is the point where you're just like, okay. You know? It's easy when, again, it's a structural change you can point to. But when it's not, when is the point where you're just like, that's it.

Michael: 09:09

This one's dead to me. Right? Put it on the shelf. Give it a trophy. You know?

Michael: 09:15

Hail Mary and all all mother and away you go. Yeah.

Dave: 09:23

The you're probably not gonna believe this, but I don't do that. I there is no kill switch for my strategies. I've been trading some for probably ten years now without modification. Mhmm. It's pretty rare that I have that to have that, you know, without any modification.

Dave: 09:46

But the way I think you do you you make that decision, from a position of strength is to be constantly coming up with new strategies. And then you're you're like general manager of a baseball team figuring out who to put in to play.

Michael: 10:08

Mhmm.

Dave: 10:08

Right? You've got a bunch of good choices. So the hard part is, you know, figuring out which one you're gonna put on the bench. But even the one I'm putting on a bench is is pretty good. So if you can create a workflow for yourself like that where you're constantly creating strategies, constantly improving strategies, it's just a it's just a way better situation to be in.

Dave: 10:31

Mhmm. And that decision to cut one off is a lot easier.

Michael: 10:36

Yeah. The, I didn't know that you never ended up cutting them off, but I did know that we are just and that's what I was fishing for. That multiple strategies is the the ticket for this, and it's one of those that we've talked about a few times where even if you don't have any buying power or capital or anything to employ another strategy, the the, you know, the resting there and saying, okay, I'm done. Right? I'm gonna run these.

Michael: 11:00

These are taking up all my buying power. I'm happy with them. I think for the systematic trader, that's kind of the the death nail. The, you know, you've you've stopped learning. You've stopped researching.

Michael: 11:10

You've stopped, you know, trying to come up with a new idea and testing it and all that, which we know is the work for us. Because you're right. It it's great to have just another strategy added in, generally, just because we know the more strategies you add, generally, just the better risk adjusted return over time. But it it does that same thing as well. So if you start to see edge erosion, well, it might just be time to implement that strategy that you've been paper trading and back testing and then doing all that work into that.

Michael: 11:37

So at least it it doesn't feel that bad that, you know, it's like, okay. You've got a a new baby to play with. For me, it's it's kinda the same way. I expect and this could be an interesting discussion as well. I expect the swing trading that I do that edge erosion to be a little bit less than I think a lot of the day trading stuff, simply because, you know, if I'm buying something and I'm holding it for a couple weeks, there's less everybody could pile on board, and there there's just less of that, I think, overall problem.

Michael: 12:08

But as I get more and more into day trading, this is something I think I definitely have to focus on more. And, again, just stacking strategy after strategy. I think it it's the way. It's way more work, but I think that's probably one of the reasons why it does so well and and why it's kind of the ticket is just to keep keep adding new strategies.

Dave: 12:25

Yeah. I think that's totally true. And, you know, when people talk about edge erosion and I think it all comes back to having a good process for creating your own strategies. And if you don't have that, you're gonna be worried about edge erosion a lot. But that's sort of the name of the game.

Dave: 12:49

I mean, that's kind of I I think the whole trading game and being good at it is how you come up with strategies, how you improve them over time. So, to to me, people that point to edge erosion and, you know, complain about it, They just need to come up with better strategies, and they, you know, come up with additional ones. And the the hard part about it is, you know, you get like, we've talked about before with with Brett Steenbarger, you get calcified. You get something that works. You feel like that's, you know, who you are.

Dave: 13:29

That's it's the kind of trading you do. It's working. You don't need you you feel like you don't need to to work to improve it. But, really, that's when you're that's the best time to improve is when you don't have to improve. You don't feel like you have to improve.

Michael: 13:47

Mhmm.

Dave: 13:48

Like, when you don't need a new strategy is really the the the prime, time to be coming up with new stuff.

Michael: 13:58

And, yeah, I would, you know, go back to the the podcast that we've talked about in the beginning where we talked about how to build strategies because, yeah, I just couldn't agree more that when when the moment comes that your system stopped working, you're gonna be very happy that you have multiples. You're gonna be very happy that you've been you've been working on that. But let's just talk a little bit more about, you know, the what is generally happening? Because some people I think we should just take a step back. Some people might not understand the the concept of edge erosion when it comes to, like, what occurs in the market.

Michael: 14:31

And and quite often what we're talking about is there's a lot of smart people out there that are looking at the market and come trying to come up with strategies and trying to build, different strategies and ideas. And so you might be not necessarily the first to a strategy, but you might be early. And let's just take something simple as, you know, most gaps fill. Let's just use a let's just say that. So you stock gaps up, you you short the gap, and that's a thing.

Michael: 14:56

Maybe that's a thing that worked for a while in seventies, eighties, that kind of thing. But as more and more people notice that, there's two things that occur. One is front running of the strategy. Right? Another way to look at it might be a moving average crossover.

Michael: 15:10

Well, if I know a moving average crossover has edge, well, I'm gonna buy it the tick before the moving average crosses over. Right? And then someone else is gonna buy it the tick before the moving average and so on and so forth until the strategy is just kind of defunct. Then the other thing is, predatory in nature. I know that there's a whole bunch of retail traders that are are shorting the second of stock gaps up, and I'm a giant hedge fund out there.

Michael: 15:32

I'm just gonna buy a whole bunch of shares and rip it up in their face and trigger their stops and and do the opposite of it. So both of those things combined can kind of that's the edge erosion that I think of anyway. The more systematic kind of everyone discover something, it gets talked about, it gets spread around, and I don't think there's any way to avoid this. So I'm always interested and interested in your opinion. There's a lot of people who think they have to keep everything really close to their chest to prevent that.

Michael: 16:01

But how much do you think that kind of edge erosion is going to happen anyway? And we're kind of talking about a little bit what you do or sharing what you do, will that actually hurt it faster, or do you think it's just if your strategy is good enough, it should hold up over time anyway?

Dave: 16:19

Yeah. My my thinking has changed about this over time. So back in when I first started trading, I would post my trades on the on Twitter and on my blog at the time, and I would do that every day. And that was back before I was back testing.

Michael: 16:42

Mhmm.

Dave: 16:42

And it when the strategy started to erode a little bit, I thought my my first thought was, man, what how stupid was it to be posting these trades online? That was just a really dumb idea. That's what caused it. Right? But the more I thought about it and the more I realized what happened, it's just the normal course of events.

Dave: 17:07

And nobody was reading my blog at the time. It was not you know? It would have to have been a huge number of people seeing it and following it and trading exactly what I was doing. Like, it it was just impossible that that would have happened. But, so I I just realized I needed a better process for myself to come up with strategies.

Dave: 17:32

I mean, there's just no question about it. So, Yeah. That's so so I don't I don't think that I don't think that, you know, holding information close to your vest to to, you know, not sharing information is gonna make a difference at all. I think you I think you're gonna get way more from sharing with other trusted traders like the you know, go back to the episode we where we talked about this. The more you give to other trusted traders, the more the the better you are at at creating trust with other good traders, I think the better off you're gonna be in the long run.

Michael: 18:16

Mhmm.

Dave: 18:16

But when you get started, it's easy to think that, oh, I've got this, you know, awesome edge. I can't tell anybody about it because it's gonna erode it. I'm not I've just I used to think that that was the case, but I just don't really believe that anymore.

Michael: 18:30

Yeah. You think you've you've figured it out, and you can't tell these mere mortals that haven't haven't discovered it yet. Yeah. And I I I would tend to agree there. I I would say maybe in some cases, if if your edge is I'd say it's more a liquidity thing than an edge erosion thing.

Michael: 18:49

If you're trading, like, very liquid assets, maybe you don't wanna talk too much about that. But, yeah, I'm I'm I'm the same way where, you know, if my again, I think it's one of those things. Maybe more sensitive in day trading than in swing trading, for sure. But, yeah, in the more you talk strategy with traders, the the more the more interesting things. So I'm actually having an example from this from my my trip to New York that I just had where, you know, I've been trying to get a little bit more in the day trading world and building strategies and working with prop firms and stuff for that.

Michael: 19:20

And I was chatting with a guy who's been day trading for ages, and he goes, oh, let me you know, we were talking about it. I was saying, listen. You know, I wanna get and he's like, oh, let me show you what what I do. And he sat down, and and for a couple days, he was sitting next to me at the conference. He'd show me when he took a trade, and this is why and all that.

Michael: 19:38

And then I was just looking at it saying, hey. I could probably automate 60% of of what you do just three, you know, trading view alerts and things like that. And I I showed him it, and I built the alert on his computer with chat GBT and and added it. And he was just blown away. So it's like, he may have given me a strategy that I can put into my quiver now when I'm going on this journey.

Michael: 20:02

And I gave him some automation for his, so hopefully made his life a little easier. So it's what we're talking about again with the whole trusted trader thing is that yeah, you never know. So, you know, we had a whole podcast on this, but create a little community for yourself and and and go through that and see. You never know. Someone may I'm not gonna copy what he did verbatim.

Michael: 20:21

Alright? I'm gonna look I look at what he did, and I'm trying to figure out a way I can systematize it a little bit better, for myself. But, yeah, just you know? So share a little bit. Right?

Michael: 20:31

It's not gonna it's not gonna ruin your trading style. That's for sure.

Dave: 20:36

Yeah. And, you know, you shouldn't, share all your secrets, you know, give away all your strategies online for free, but you should develop and cultivate your own trusted trading group and trusted contacts.

Michael: 20:56

Mhmm.

Dave: 20:56

Do network you know, like like Mike Belafore says, networking is a trading skill. So Yep. That that's definitely the case. There so there's others there's one other dynamic here that I'll, I've noticed. Sometimes you get somebody that has been in in the trading world for a long time, and they used to trade a strategy that maybe has gotten out there and more people trade.

Michael: 21:26

Mhmm.

Dave: 21:27

And back when they were trading it, they you know, it had a lot of edge. It was earlier on that edge erosion curve that we talked about.

Michael: 21:38

Mhmm.

Dave: 21:39

But for that trader, they moved on to something else, and they've created strategies for you know, better strategies for themselves. So they've they've moved on to something else. But they would say that, oh, yeah. That stopped working. That no longer works.

Dave: 21:54

But when you see I've seen I've I've seen this among the traders that I work with. Newer traders who are very hungry and don't have that experience would look at that same strategy and say, man, this has some edge here. I'm gonna I'm gonna trade this. So I think there is some of that dynamic where very experienced traders used to trade something. They say it doesn't work anymore.

Dave: 22:19

That very same strategy or something, you know, the same idea, the similar strategy. A newer trader that's more hungry comes along and it it still works or it has plenty of edge for that person. So I think there is that dynamic, and that's why you see, I think, this edge erosion kinda, catch fire, and you see these flare ups on on Twitter about, how edge erosion is you know, the sky is falling, basically.

Michael: 22:48

Well, I think there's, yeah, there's a couple things there. It's one of those, you know, yeah, if you've been trading for a long time, you've got five or six strategies. You're more ranking on, what do I have buying power for? Right? If I have a wicked strategy and a good one and a kind of okay one and one that's, in my opinion, just meh, you throw that meh one or you don't apply a lot of capital to it because you've got all these wicked.

Michael: 23:10

But someone else looks

Dave: 23:14

at that and says, well, I have nothing.

Michael: 23:14

You know, this strategy that you just looked at and did whatever, I would kill just to have something that is profitable at all, right, that when you're when you're getting started. The other thing I wanted to ask you, so you mentioned, right, strategy someone develops strategy, trades it, everyone could fix it up. It gets the kind of edge erosion, and they stop trading it. Just always wonder made me start to think, is it kind of like fashion where it all comes back around eventually? Because if you think if you march that full cycle through your brain, somebody starts trading something, it works great, then it stops working, they stop trading it.

Michael: 23:51

If that's happening to everybody, then, right, eventually, wouldn't just everybody lose money, stop trading the strategy, and then the strategy just kind of picks up again and that cycle repeats?

Dave: 24:02

Yeah. I never thought about it that way, but it's I think there is something to, like, the herd mentality of, you know, following gurus, following successful traders, what they're doing. And, yeah, I think there is definitely something to that. I never thought about it exactly that way with fashion, but, yeah, maybe, in one of my, text threads I'm on with some college buddies, somebody sent a picture of, back when we were in college. Good thing it wasn't social media back then, but, we were wearing these, there was a picture, and a couple of us were wearing these really light blue jeans that were cop were popular at the time.

Michael: 24:44

Mhmm.

Dave: 24:44

And somebody said, gosh. Were those even in style back then? I mean, it just looks so so crazy, that that that kind of picture. But, yeah, I think I think I think there's something to that.

Michael: 24:56

Well and that that is what happens with fashion. Right? If someone comes out with some bold look that only they're wearing, and then everyone goes, oh, that looks good. And then they all wear it, and then it's lame. So everyone stops wearing it, and then it becomes interesting.

Michael: 25:08

So I just wondered if if it was the same. Because I've done this before where I've dug up, old trading strategies that maybe I hadn't been trading or hadn't been looking at too much, and they just they seem to be okay. And and I didn't think of the guru part of it, but that could certainly be the case where there's, you know, some really big names pushing some really big strategies, and they get overcrowded. And then the guru usually moves on with his life or changes, and then those people are are kinda left behind. So I really think, you know, kind of the main takeaway, and if there's any other, certainly let me know, is that you gotta always, a, be building new strategies, and you always have to be trading multiple systems and multiple time frames, multiple instruments, what it whatever ends up being.

Michael: 25:53

But you never know when they're gonna erode and, you know, if we're right with the whole fashion thing, you never know when they're gonna come back. So it's just best to be doing as much as you possibly can across as many different styles and strategies as you can. And you can only do that if you're a systematic trader. Right? It's I couldn't imagine a discretionary person day trading 10 different styles and then also doing some swing trading and some options or whatever.

Michael: 26:19

I think the only way that you can diversify yourself like this is if you become kinda systematic in nature where you have all of these different, ideas that that you can you can do at once because you're not spending a lot of brainpower on on each individual one.

Dave: 26:35

Yeah. I think that's true. Yeah. I think I I think, certainly, it's a lot easier to do it systematically. I know I know some traders that you know, I used to think that there were hardly any, really successful discretionary traders, but, some traders I work with now that they are they do really well, and and they have a a significant discretionary component.

Dave: 27:01

So but I think it is easier for mere mortals, to trade systematically. I think it's just there's just so many more benefits. It it it really resonates with a lot of people and people, you know, somebody like like, developers. Like, if you if you're a developer, you're gonna it's just gonna resonate with you more to be able to do it and to to trade systematically rather than discretionarily.

Michael: 27:28

Yeah. Well, right, I think we'll probably preach in the choir at this point. But for me, yeah, it certainly changed, what I what I do and and how I do it to become more systematic. And, I think it's it's one of those things that if you're if you've been following the podcast this long and you haven't figured out ways to to kinda push into those systematic boundaries, you should definitely do it. And I think strategy erosion is is one of those because I remember, right, starting out at trading and just trying to figure out what is the one thing.

Michael: 28:00

And and, basically, what we're trying to tell you is that that one thing, even if you find it, it's not gonna be there forever, or it's just not gonna work as well. So make sure that you're, right, you're pushing on to, kinda whatever that next type of thing is and and going from there.

Dave: 28:17

Yeah. There's another dynamic that I just thought of as you were talking there. And that's, you know, somebody that has traded a strategy for like, the the very experienced trader that has traded this strategy and then has moved on to something else because it's, quote, unquote, stopped working. Typically, you know, the longer you're successful, the the bigger your trading account gets, the more size you're trading with. So that same strategy may have eroded simply because they're trading it with bigger size.

Dave: 28:46

And, you know, that's a whole another dynamic that, that will make it seem like it's eroding because you're trading it slowly with bigger size over time. So, this the exact same signals or results that you would see from a strategy simply eroding, you would see the exact same sort of thing if you increase size to, you know, pushing the capacity that that strategy has.

Michael: 29:20

Yeah. And at least that one would be probably fairly easy to test. Right? Size back down the second you start noticing that erosion. And then if it that goes away, then, you know, you've just kinda come across the cap of of what it is that you can push out from a liquidity point of view.

Michael: 29:35

So, yeah, that's never thought about that. That's a good step one. Just size it back. And if if it still looks like it's eroding a little bit, well, you'll be happy that you sized it back anyway. But that will probably lead to step two.

Michael: 29:49

And, again, try to fix it and try to to see what you can you can tweak from there. But and ever you know, it's one of those things that I knew in my brain, but it's good to remind people that sometimes it's it's your fault, I guess, that the strategies are eroding eroding because you're just Yeah. You've gotten too big. Good problem to have. Right?

Michael: 30:06

It means you've found something that works, and you've just hit a liquidity constraint on it. So you can only make x amount of money on it. But, again, it's a better problem than to to not be making anything. That's for sure.

Dave: 30:17

Yeah. And, you know, whether you believe edge erosion exists or not or how big of a problem it is, Really, this the solution is the same, or what you should be doing is the same, like we talked about. Work to improve your strategies, work to come up with better ones.

Michael: 30:37

Mhmm.

Dave: 30:38

And that, know, in the long run, that's gonna put you in a better position where you are, you know, just improve over time, and then you don't really have to worry that much about edge erosion.

Michael: 30:49

Yep. Trade multiple strategies. I think that's the the lesson that we're kinda hammering on. So, it feels good to be back. Right?

Michael: 30:57

It feels good good to be back in the saddle. I'm glad we're gonna be we're gonna be recording again for the audience because we always have a buffer. It seems like nothing happened. But, you know, I got those little little nerves back again for the first few minutes, but ends up just being a a good old conversation amongst amongst nerds like it always is. So, again Yeah.

Michael: 31:16

Appreciate everyone for hanging out. Appreciate everyone for listening. And, until next time, I'm Michael Noss.

Dave: 31:23

And I'm Dave May. We'll talk to you next week on Line Your Own Pockets.