How To Exploit The 80/20 Rule In Trading & Investing 2
Readers who have more experience trading would have realized that the dynamic being described in Part 1 is what is expressed in the old trading adage “Cut your losses quickly and let your winners run”.
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…
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