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Strategies & Market Trends : Strictly Buy and Sell Set Ups -- Ignore unavailable to you. Want to Upgrade?

To: chowder who wrote (9168)	4/15/2006 2:41:09 PM
From: chowder	Read Replies (3) \| Respond to of 13449

A Real Example of the 80/20 Rule ................... At the end of each quarter, we review each of our services to look at what went well, what didn't, and then we discuss how we can make each service a little better in the coming quarter. The end of Q1 2006 was no different. But in looking at a trade-by-trade record of each of our services, I was reminded of something that all traders too often forget. So today, I'd like to use our Aggressive Stock Trader service as a real-life example of the 80/20 rule. It's a valuable lesson for all of us. The '80/20' rule isn't necessarily a trading concept. It's actually a pretty accurate assessment of how most things in life are proportioned. For instance, 80 percent of your sales come from 20 percent of your customers. Or, 80 percent of your time is spent on 20 percent of your job tasks. Point being, not all things are equal. The same is true in trading. Would you believe that 80 percent of your total profits come from just 20 percent of your trades? A veteran trader would tell you, yes, absolutely. However, many of us - especially when we're starting out - tend to think that getting consistent big winners is the key. If only! The reality is that only a few of your trades will ever rally be monster-sized winners. On the other hand, you don't need all of your trades to be monster winners to be a successful trader. In fact, any other expectation is a recipe for disappointment. Like so many things in life, in trading, look for 80 percent of your profits to be generated by only 20 percent of your trades. To illustrate this point, let's examine the Aggressive Stock Trader trades that were closed out in first quarter (which means some of them were opened before Q1 began). There are a couple of assumptions about this model portfolio. First, we allocated 10 percent of the portfolio's cumulative value into each new trade. And second, we began with $100,000. By the end of the first quarter, all the trades closed out during that time brought the portfolio's value up to $108,980 (which includes commission costs), for a gain of 8.9 percent. That's not bad, give that the market was incredibly choppy, and the best performing index only returned 6.1 percent in Q1 (the NASDAQ Composite). In other words, we'd consider this service a pretty successful (and fairly typical) trading portfolio. Take a look at the spreadsheet, and pay special attention to the number of winners (and big winners. specifically). ttrader.com Anything surprise you? Of the 19 closed trades, only nine of them were profitable. And only four of those nine were wins of greater than 20 percent. Yet, the portfolio still did very well, especially for a choppy market. But was it truly a case of the 80/20 rule? Let's see. The portfolio gained $8,980 on 19 trades. Let's take another look at the spreadsheet, this time with the actual dollar amount of gain or loss on each trade. The sum total of profits generated by the four 'big' winners is $13,589.17. So, 21 percent of the trades generated more than 100 percent of the total gain. In this case, the 80/20 assumption was a bit too conservative.....it was more like the 100/20 rule! ttrader.com And the point? There are two things to take away from this analysis. First, controlling expectations is half the battle. Too many traders would have needed to see all nineteen trades look like those four great trades. But, that's just not realistic. That in itself isn't a problem until the trader starts to make bad decisions based on disappointment and unrealistic expectations. Even the most disciplines trader in the world with a great trading system can't overcome the 80/20 rule. That's just life, and that's why described our Aggressive Stock Trader results for Q1 as 'typical'. Second, although we rely on a handful of our trades to be big winners that leave us with big net profits, we can't tolerate a lot of big losses. And in trading, 'never losing big' is at least as important as 'winning big occasionally'. Of the nineteen trades we closed, there was only one loser of any size - the 13 percent loss on a GSI Commerce short trade. That loss was inflicted in just one day, so there wasn't a lot we could do about it. But, it was still a bigger loss than we'd ever take if we had a choice. Note that all the other losses were pretty small. That's why our few big winners so effectively carried the portfolio up by 8.9 percent. This is an exercise in discipline, but a good practice to get into. Keep the 80/20 rule in mind as you progress through Q2, and be sure to take a look back when June turns into July. Odds are that only a few of your trades will be responsible for all your profits. That's just the nature of the game, so don't lose sight of that concept. BigTrends.com (This message is linked to previous articles.)