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The 80/20 Rule of Trading
01/23/2012 11:58 am EST
Frank Kollar of FibTimer.com explains that because the overwhelming majority of trading profits comes from just a small percentage of trades, it’s critical that traders not be discouraged by losers, and that they take steps to limit losses and let winners run.
Trend traders depend on change to make their strategies work. Simply said, a market that just goes sideways cannot be timed. But a market that trends up and down can be.
History shows us the financial markets are usually in trends. You can go back hundreds of years; you can look at stock markets, commodity markets, Dutch Tulips, you name it, they are more often than not in trends.
History also shows us that trends usually last much longer than anyone expects.
For example, after a huge upward trend through most of the 1990s, the US stock markets were in a downtrend (bear market) from 2000 into early 2003. Any chart can easily show you the trends.
For the next several years, into 2007, the financial markets were in a solid uptrend. Then we again suffered through another downtrend, but Fibtimer subscribers made money instead of taking the 50% losses that most investors suffered.
Overall, financial markets are in defined trends about 80% of the time. This has been the case for many, many years.
Sideways Markets Are Actually Good News
But what about those sideways times, the times that try our patience and our will?
The good news is that sideways markets are always either the base or the top of a new trend. That means the next trend is around the corner when we are enduring a sideways market. We just have to make sure we are on board and profiting when it happens.
That is where trend trading comes in. We establish a set of rules that identifies when a trend has begun. If the trend fails, we exit. If it continues, we stay with the trend no matter how long it lasts; months…even years. After the trend fails, according to our pre-set rules, we exit.
Ever heard the saying, “Cut your losses short and let your winners run?”
Think about how powerful such a trading strategy is. You never miss a trend, either up or down. At tops and bottoms, you may get some small whipsaws as the market becomes volatile and false trends occur as the markets consolidate and decide which way the next trend will go.
If we encounter a whipsaw, it will result in either a minor loss or small gain because our money management rules, built into the strategy, do not allow losses to build. But that whipsaw is just the precursor to the next trend. In fact, they could be considered exciting times because we know that they are just setting up our next big trend and big profit.
The 80/20 Rule
Have you ever heard of the 80/20 rule, also known as the Pareto Principle? Dr. Joseph Juran developed the Pareto Principle after studying the work of Wilfredo Pareto, a nineteenth century economist.
The Pareto Principle states that a small percentage of your efforts (typically around 20%) will create a large majority of your results (usually around 80%).
Expanding Pareto to trading, it follows that roughly 80% of your profits should come from only 20% of your trades.
That means there likely will be numerous small trades that achieve little, but that only 20% of the trades you make will make nearly all of the profits.
Think how important that makes every trade!
After a small loss, it is human nature to feel like giving up. This is the psychological battle that market timers must win!
The markets are powered by emotions (fear and greed). But trend traders use the changes caused by those emotions to make their profits.
If you give in to those emotions, you lose!
See related: Don’t Let Emotions Get the Best of You
Here at FibTimer, where we have been market timing for over 20 years (since 1982). We always know when a new trend with huge profits is near.
Subscribers become nervous. Financial news becomes overly positive or negative. The number of reasons why the markets cannot go higher (or lower) increase.
Soon after is when the big trade occurs, and we make our big profits for the year.
It happened during the bull market top in 1999-2000. The ensuing decline, a strong and powerful trend lasting over two years, realized a 100% gain as the stock market collapsed.
It happened in March 2009 when everyone was bearish, but our buy signals in that month put us into the beginning of a market advance that lasted a full year with well over 50% gains.
Think about the 2008-2009 bear market. Even our conservative subscribers were 50% ahead of the buy-and-hold crowd because they were in money market funds missing the entire decline.
Knowing that you will be on the correct side of every trend means you will be in the next rally or bull market; or out of the next steep decline or bear market.
These are more than just comforting thoughts. They are critical to profitable strategies in troubled times.
By Frank Kollar of FibTimer.com
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