The Universal Statistical Edge (USE) Principle

Most traders spend years of inane efforts without achieving consistent profitability due to a fundamental misunderstanding of the nature of the edge in the activity of financial trading. They are in fact looking for (purely hypothetical) information contained within the market data and essentially guessing and chasing price movements, often through indicators and signals while neglecting Historical Trading Information (HTI) self-generated by their own trading activity. As a matter of fact the lack of an edge is fundamentally imputable to the lack of HTI utilization in the formulation of future orders. It turns out that losses are an expression of "loss" (or disregard) of such type of information.

What is the foundational cause of lack of consistent long-term profitability

Disregarding the self-generated HTI will generally lead to unprofitability for several reasons:

Loss of information (not data information, but HTI): Neglecting the self-generated Historical Trading Information (HTI) Many traders focus essentially on guessing some aspect of the market, either of directional or dispersion (volatility) nature on short-term price trends, formulating "local" bets with some form of stop-loss and take-profit without taking into account the big picture of the whole structure of their trading activity.
Order Cloud Inconsistency: Consequent to this loss of HTI, when trades are executed independently - without conditioning the probability of new orders on the structure of the cloud of orders already executed, inevitably it can happen that the average price of the buy orders end up being above the average price of the sell orders. Which is the definition of long-term unprofitability.
Failure to utilize (induced) price recurrence: Without taking into account the HTI, and especially the portion of it related to the most unfavorable orders, traders are not able to exploit that information in the formulation of the probability of future new orders, thus causing a fatal loss of crucial information. The continuous failure to take advantage of the structure of the order cloud being developed during trading activity ultimately destabilizes the trading account leading to long-term unprofitability.

It has been proven formally that the utilization of the HTI leads to strategies that in the long run are infinitely better than any strategy that does not use it. In other words, not using the HTI leads to uniformly dominated, conceptually inadmissible, trading strategies. This fundamental breakthrough result, that can be found in the seminal paper by Prof. T. Gastaldi , is also referred to as the Universal Statistical Edge (USE) principle.

So, while there is a mathematical proof of a real and objective statistical edge, on the other hand, most traders still chase the illusion of information hidden in the data, an unfalsifiable stance, which is akin to guessing and gambling rather than trading strategically based on a true statistical edge. This sort of statistical ignorance and fallacious beliefs are, on the other hand, the basis on which market makers thrive.

Universal Statistical Edge (USE) Principle: A Necessary Condition for Building A True Edge

The Universal Statistical Edge Principle emphasizes that effective trading strategies must rely on historically informed decisions. While having a theoretical edge is a crucial prerequisite, it represents a necessary condition. In the real world, we must also allow this edge to emerge within the constraints of available capital. It is, in fact, obvious that any type of edge, no matter how effective, cannot guarantee success, especially when there is excessive exposure.

This aspect is easy to understand in practice. One example can be drawn from the Kelly criterion. While it does not apply directly to the complex setup of trading—where we cannot assume the independence of orders—it exemplifies a fundamental principle. In a simple independent betting setup, even with a strong probability in your favor, there is always a bet size that can lead to bankruptcy before the edge starts working for you, regardless of how good it is (Kelly, 1956).

While the Kelly criterion provides valuable insights into managing exposure, its foundational assumptions, such as the independence of bets (or orders), do not align with the realities of real-world trading. The USE Principle emphasizes that to formulate non-dominated trading strategies effectively, traders must condition the probabilities of future orders based on **Historical Trading Information (HTI)** obtained from past trading activity.

More Essential Pillars for Success:

Effective Hedging: The ability to hedge effectively when market conditions turn unfavorable mitigates losses before they escalate, providing a safety net for traders.
Exposure Control: Effective management of exposure is critical. It involves recognizing the total risk one is willing to accept per trade and ensuring that the edge is effectively utilized without jeopardizing the account during adverse market conditions.

Conclusion

Consistent profitability requires a deep understanding and applying the Universal Statistical Edge Principle and implementing robust risk management practices, including exposure control and timely hedging. The ability to use HTI to condition future trading decisions is crucial in moving from merely guessing in the markets to trading with a true rational edge. Anyone committed to trading should integrate these principles into their strategy in order not to create fallacious trading procedures.

Learn More

For a deeper understanding of these concepts, you can consult the seminal breakthrough paper or this more accessible reduction.