The key to finding an edge

The key to finding an edge is to find market anomalies. Markets are not random. For many years studies after studies have shown two anomalies which make profits

1 PEAD- Post Earning Announcement drift
2 Momentum effect


PEAD- Post Earning Announcement Drift

Each quarter when companies report their earnings, there are usually a handful of companies whose earnings are either surprisingly good, or shockingly bad. You can immediately recognize these companies by the post earnings announcement jump or plunge in their respective stock prices. So far so good. But now fast forward, say, three quarters. If you take a look at all the stocks that had negative earnings surprises, you find that on average these stocks continued to go down. Similarly, the stocks that had positive earnings surprises continued to go up, on average. In other words, the stocks with earnings surprises exhibit post earnings announcement drift, or PEAD for short. Now this is weird. Every finance professor will tell you that this isn't suppose to happen. If the stock market is efficient, what should happen is a one-time jump in the stock price when earnings are announced.

This PEAD effect was first identified in a paper published in 1968, almost 40 years ago. Generally, when research on market inefficiencies is published, people start trading against the inefficiency and the anomaly goes away. But not with PEAD. Subsequent papers have overwhelmingly found the same result. PEAD is considered one of the most robust stock market anomalies around. And, so far, nobody really knows why....

Momentum effect

There is substantial evidence that indicates that stocks that perform the best (worst) over a three to 12 month period tend to continue to perform well (poorly) over the subsequent three to 12 months. Momentum trading strategies that exploit this phenomenon have been consistently profitable in the United States and in most developed markets. Similarly, stocks with high earnings momentum outperform stocks with low earnings momentum.

Hundreds of studies have shown this behavior continues in the market years after year. Like this there are many anomalies and if you find them you will not have to worry about making money and losing your edge. I basically trade 5-6 such anomalies. Each one of them have a statistically proven edge and logic as to why they work.

Many of these things are in public domain for years. Why people don't trade them, because most people are lost in technical analysis jungle. Secondly many people trade on too short a time frame to capture returns from such strategies. Some of the most profitable systems are based on finding such anomalies.