From a more abstract perspective, this can be understood as: since we live in a Paretian world, we understand that a lot of the time we will not get lucky; BUT the few times we do get lucky, we will get very lucky.

Hence, it follows that when we do get very lucky, we need to let the luck ride for as long as possible. The general idea being to make as much as the market allows you to make when you do get lucky, within one’s tolerance for risk.

This can be achieved in a variety of ways, the simplest of which is through the use of trailing stops.

Trailing stops let the market take you out of the position, as opposed to exiting at a predetermined point. They work well when markets are trending strongly (i.e. Pareto effects are in full swing), since no one can time the exact high or low, and setting a maximum profit target will serve to cap your gains.

The only time a take profit level will not cap your gains is if the market turns before your preset level is hit. However, a trailing stop is still required since the top can only be observed in retrospect, and leaving the position open without a stop is not generally a good idea.

Since a stop is needed anyway, it tends to be wiser to let markets take you out of positions. 

More aggressive strategies involve pyramiding, which is just a fancy name for adding to the position when the market goes your way. Of course, each addition to the original position increases the trader’s risk, and hence is not something that should be done without limit. 

Another one is to own long dated out of the money options. This works because out of the money options tend to be cheap, and traders can enter into some pretty large positions. Should a large market move occur and push these options into the money, the trader would make a lot of money.

This happens not just because of the option moving into the money, but also from changes in implied volatility, the convexity of long dated out of the money options, and finally from the leverage inherent in all option contracts.

Last but not least, if you want to go the managed money route, CTAs (Commodity Trading Advisors), more commonly known as trend followers, are big proponents of “Cut your losses quickly and let your winners run”.

Their strategies are almost always entirely built around the central Paretian truth of the adage, with tight stops to cap downside risk and measures to maximize profit from when they do get lucky.

To be continued…

The problem starts with the many, many times we do not get lucky, and must minimize our losses so as to be able to stay in the game.

Big losses in a Paretian environment tend to be catastrophic, and very difficult to recover from. Again, trailing stops are an invaluable tool here, as they help cap losses while locking in profits as the market moves in a position’s favor.

More importantly, trading in a way that takes advantage of Pareto effects is psychologically taxing.

This is due to the fact that a trader has to take many, many small losses, without knowing when the big trade is arriving, a process that has been referred to as “death by a thousand cuts”. 

This causes mental and emotional stress, as our human minds generally feel the negative emotions that arise from consistent losses more acutely than the positive ones from large but irregular gains. Moreover, when trading in such a manner, one cannot afford to miss a trade, since any trade can be the big one.

As such, many people fail in successfully executing such strategies because of the psychological and emotional stress.

Of course, “taking many small losses” varies in form, largely depending on the trader’s strategy.

For CTAs (aka trend followers), small losses are known as “whipsaws”. This occurs when CTAs take positions in a market that they think is trending, but turns out not to be (no one knows beforehand when a market will trend).

A popular way these traders decide on whether or not to take a position is by looking at markets that are breaking out of previous ranges. Unfortunately, most breakouts turn out to be false moves, and prices quickly drop back into the previously established range.

When this happens, CTAs get stopped out and take the small loss, which is of course exactly what their strategy demands of them. However, since most breakouts don’t lead to robust trends, CTAs end up having to take many small losses before a nice trend comes their way.

Again, this is in line with their strategy and trading philosophy, but the stress of having to take so many consistent losses and seeing one’s trading account shrink accordingly causes many to give up.

A good real life example of this is the trading experiment run by Richard Dennis and William Eckhardt. The two men demonstrated that it is difficult, but possible, for anyone to be taught to become successful traders by adhering to trend following rules.

It goes without saying that when a trader gives up in a Paretian environment, they lose their chance at making back previous losses (not to mention profits on top of that), since they are no longer exposing their trading account to positive Paretian effects, i.e. the big one.

Consequently, it is a popular misconception that good traders are the most intelligent, most hardworking, and most risk seeking individuals.

These qualities can be useful, of course. But ultimately, good traders are the ones that understand that we live in a Paretian world. And have the mental and emotional stamina to consistently execute a trading strategy that is designed around Paretian realities.