# Using the Pareto principle in trading



## It's Snake Pliskin (2 February 2010)

On another thread I saw some comments regarding using the Pareto principle in trading. So how does it apply to trading and who allows for it?


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## Kryzz (2 February 2010)

Is it fair to say that the Pareto principle is taken advantage of in the equities market primarily, as opposed to other commodities/derivative markets etc?


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## Trembling Hand (2 February 2010)

Did i just travel to a parallel universe. 

Anyway I'm with you snake. How do you apply it? If its actually something that can be applied rather than just an explanation of distribution.


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## tech/a (2 February 2010)

*T/H *------But you dont know which trade is going to be the trade which brings home 15R.

*Tech*-------Correct and its the big R multiples you want.
This is what I do in my own discretionary trading.

(1) I set very tight initial stops I dont want to be trapped in the no mans land of trade triggered stop in tact trade is doing nothing.
I also get a much tighter R/R. and potentially quicker larger R/Rs.

(2) I get out of exponential trades as quick as I price indicates (3 min charts tell the story at tops).
My own personal stat search indicates around 50% of trades which move 30% in a day will come off tommorow.
50% moves have even higher and 100% close to 80% come off so sell at close or near to it has proven wise.

(3) Those which move pause and move into a range are cut.
I have a formula I use to move stops in ranging stocks.

Just a matter of standing in front of and staying on board Trains!


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## Whiskers (2 February 2010)

It's Snake Pliskin said:


> On another thread I saw some comments regarding using the Pareto principle in trading. So how does it apply to trading and who allows for it?






Kryzz said:


> Is it fair to say that the Pareto principle is taken advantage of in the equities market primarily, as opposed to other commodities/derivative markets etc?






> The Pareto principle (also known as the 80-20 rule,[1] *the law of the vital few*, and the principle of factor sparsity) states that, for many events, roughly 80% of the effects come from 20% of the causes.[2][3] Business management thinker Joseph M. Juran suggested the principle and named it after Italian economist Vilfredo Pareto, who observed in 1906 that 80% of the *land* in Italy was owned by 20% of the population; he developed the principle by observing that 20% of the *pea pods *in his garden contained 80% of the peas.[3] It is a common rule of thumb in business; e.g., "80% of your sales come from 20% of your *clients*." http://en.wikipedia.org/wiki/Pareto_principle




Maybe it's just me, but I think many people use the principle/rule at least to some extent, without even realising it.

Lobbyists target those few people who control the decision making, rather than an indiscriminate group off the street.

Researchers/plant and animal breeders identify products/plant and animal varieties with sought after characteristicts, ignore the rest, to improve their prospects of producing better products/plant and animal strains 

Yield investors select sub groups of companies/investments with the best history/prospect of high yields and ignore the rest... similarly capital gain etc.

If you want to buy large tracts of land in Italy, cost effectively, find the 20%... those who control large tracts of land as opposed to indiscriminately dealing with the first people you come across.

That's basically how I understand and use the principle... and ditto for your investing/trading system rules, indicators and management.

In short cull the less relevant and less effective and focus on your selected 'Train' (as Tech/a puts it) with a stratergy to essentially lock in as much profit/gain as you can.

But, to refer to a problem mentioned again in a segment on Catalyst on the ABC last night, where company boards are increasingly appointing 'Psychopaths' to high level decision making often to the detriment of the company... because the company staff 'selection criteria' seeks out go getters, influental high achievers. Just the stuff that Psychopaths excel at and companies inadvertantly appoint... to the later expense of staff moral, customer relations and further down the line, turnover and profits.

I suppose the moral of the story is to beware that we might select and install a 'psychopath' in our system, literally or figuretively... and bugga-up our pareto principle.


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## tech/a (2 February 2010)

Whiskers.

Your right.
We no longer do small projects not because we cant but we can produce much more chargable Square meters/day with the same infrastructure.
Up to 5X.
Profit goes exponential!


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## ginar (2 February 2010)

Maybe this Pareto principle will work for a lot of traders . im sure that those who accept mediocrity in successful trade ratios need to work very hard on the top 20% of trades as thats possibly where ALL their profit is .


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## ginar (2 February 2010)

ginar said:


> Maybe this Pareto principle will work for a lot of traders . im sure that those who accept mediocrity in successful trade ratios need to work very hard on the top 20% of trades as thats possibly where ALL their profit is .




And if anyone actually fits this bill i suggest you forget the Pareto principle and just work on method . Sometimes all this intellectual snobbery  gets in the way of what really isnt that complicated . Trading is defining probabilty and managing possibility . Working on those 2 is all i concern myself with


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## marknz88 (2 February 2010)

My understanding was that profitable traders make 80% of their profit, from 20% of their total trades...

I dont really think you can apply the principal any other way really? Happy to be proved wrong.


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## yonnie (2 February 2010)

dont know anything about the Pareto thing, but what I`m reading here it means nothing more than cutting your losses short and letting your profits run.

I agree with Ginar: just get the most out of your trades.

but not all share trading comes under this heading...........mine is not and I still make a very good profit.
probably comes close to scalping.


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## Trembling Hand (2 February 2010)

Whiskers said:


> In short cull the less relevant and less effective and focus on your selected 'Train' (as Tech/a puts it) with a strategy to essentially lock in as much profit/gain as you can.




Of course that ignores the fact that markets do not offer the same all the time. And that is one reason people Blow up. looking for 10 R winners when there is only 2r on the table then take 3R when 10 R was there.

Its fine stepping away when the runners are not available but I think over the long run you are better just adapting to what the market is offering.


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## weird (2 February 2010)

Interesting research paper by Blackstar funds,

"The Capitalism Distribution" Research Paper 

http://www.blackstarfunds.com/files/TheCapitalismDistribution.pdf


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## tech/a (2 February 2010)

Trembling Hand said:


> Of course that ignores the fact that markets do not offer the same all the time. And that is one reason people Blow up. looking for 10 R winners when there is only 2r on the table then take 3R when 10 R was there.
> 
> Its fine stepping away when the runners are not available but I think over the long run you are better just adapting to what the market is offering.




Hmm
You can't do both?
You don't take a larger R multiple if it's there?
Sure you can do well with 80% win rate and low R
I wouldn't write off applying the principle in trading.
More than one way to post a profit.


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## Trembling Hand (2 February 2010)

tech/a said:


> I wouldn't write off applying the principle in trading.




You haven't showed how to use the principle. Its not rocket science to say that if the markets moving let it run, its also not application of Pareto principle.

The bottom line is if you take a historical set of trades and somehow find what sets up the top 20% and then only trade that you are only going to have 20% of your historical profit, probably as a best case. It is likely that just because you had 20 outliers in your last 100 trades your chasing random conditions.


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## weird (2 February 2010)

Trembling Hand said:


> You haven't showed how to use the principle. Its not rocket science to say that if the markets moving let it run, its also not application of Pareto principle.
> 
> The bottom line is if you take a historical set of trades and somehow find what sets up the top 20% and then only trade that you are only going to have 20% of your historical profit, probably as a best case. It is likely that just because you had 20 outliers in your last 100 trades your chasing random conditions.




T/H, I think Tech/A has mentioned within prior posts in this tread, cutting losers, letting the winners run ... those large multiple R fall in the top 20-25% percent.

I don't believe Tech was alluding at trying to find those 20% only, but making oneself available to them, by trading the full 100% ... and cutting losers. This is Trend Following 101, I trade a system which uses profit targets, but raises stops aggressively ... hence the name Belayer, such as used in rock climbing ... this system will never have outliers or very very few.

Many different ways to trade.


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## nunthewiser (2 February 2010)

weird said:


> Many different ways to trade.





BINGO!

sorry for lack of content post but that needed to be said for those that dont believe in anything other than there way.


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## tech/a (2 February 2010)

weird said:


> T/H, I think Tech/A has mentioned within prior posts in this tread, cutting losers, letting the winners run ... those large multiple R fall in the top 20-25% percent.
> 
> I don't believe Tech was alluding at trying to find those 20% only, but making oneself available to them, by trading the full 100% ... and cutting losers. This is Trend Following 101, I trade a system which uses profit targets, but raises stops aggressively ... hence the name Belayer, such as used in rock climbing ... this system will never have outliers or very very few.
> 
> Many different ways to trade.




All I can do is set myself for high R multiple trades.
I have no idea if the next trade sill be in my top 20% 
but I do know that if a true outlier comes along my R multiple won't
be high it will be spectacular.
For someone who advocates the stupidity of attempting
to be right you certainly seem he'll bent on insisting how I
can be right in finding my top 20%
ain't going to happen I'm not interested in being right just around for
those rare blackswans


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## weird (2 February 2010)

tech/a said:


> All I can do is set myself for high R multiple trades.
> I have no idea if the next trade sill be in my top 20%
> but I do know that if a true outlier comes along my R multiple won't
> be high it will be spectacular.
> ...




Tech, I assume some of those comments were not directed to me.

I have been friends with Tech/A for over 5 years, he trades, just like T/H ... they perhaps trade differently, not sure why there is a sparring match between them atm. I respect both traders.


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## Trembling Hand (2 February 2010)

tech/a said:


> All I can do is set myself for high R multiple trades.
> I have no idea if the next trade sill be in my top 20%
> but I do know that if a true outlier comes along my R multiple won't
> be high it will be spectacular.
> ...




LOL tech you are a joke. 

You are kidding yourself if you think that *you *actually apply Pareto principle.

You Don't Apply it. Its just the distribution of profit.


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## tech/a (2 February 2010)

No------- T/H


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## Trembling Hand (2 February 2010)

tech/a said:


> No------- T/H




No what?


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## tech/a (2 February 2010)

Trembling Hand said:


> No what?




No Wierd my comments are directed to T/H and his comments
clear enough?


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## weird (2 February 2010)

Alright girls, T/H back down, it is obvious on the forum you have been riding Tech/A since he started posting again, not sure why, Tech/A is an experienced trader, and has a lot to offer. T/H you are an experienced trader, and your posts are en-lighting on dodging the  bs, and giving real gems ... but there appears to be an unknown vendetta here, which most don't want to know about ... Tech/A is a real trader ... give him the courtesy of some space.


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## Trembling Hand (2 February 2010)

Sure, last words.

Using the Pareto principle in trading = let ya winners run.

got it.


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## It's Snake Pliskin (3 February 2010)

Trembling Hand said:


> Sure, last words.
> 
> Using the Pareto principle in trading = let ya winners run.
> 
> got it.



I started this thread to get some discussion on the P Principle and its application. I believed it wasn't an applicable device (for lack of better words) and more the result of focusing on the better trades that come about. A principle for talking about results perhaps.

TH seems to have summed it up well.


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## skc (3 February 2010)

It's Snake Pliskin said:


> I started this thread to get some discussion on the P Principle and its application. I believed it wasn't an applicable device (for lack of better words) and more the result of focusing on the better trades that come about. A principle for talking about results perhaps.
> 
> TH seems to have summed it up well.




I guess letting your profit run is in a sense applying the principle. Although it is a chicken and egg issue to me... i.e. Did you let profit run and so the results become 80/20, or did the 80/20 principle led you to let profit run?

I am a big fan of the Pareto principle - it is so useful in business planning, cost reduction etc. So it can be applied to the business aspect of trading to some extent. For example, a trader runs several strategies, each requiring roughly equal effort, but her returns are heavily skewed towards 1 or 2 strategies. Then the obvious answer is to concentrate only on those most profitable ones and forget about the less profitable ones. 

The other one relates to trading costs. No point phoning around trying to get cheaper internet connection, when a phone call to your broker to get commission down a couple of notches will have a much larger effect...


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## tech/a (3 February 2010)

With regard to T/H.
I enjoy his postings and his standing on subjects.
Without both I wouldnt be here!


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## tech/a (3 February 2010)

Trembling Hand said:


> Sure, last words.
> 
> Using the Pareto principle in trading = let ya winners run.
> 
> got it.




Easy to dismiss in a cursory manner if thats what you wish to do or believe.

I personally think there is more to it.
Firstly its about observing and admitting that 80% (or a larger amount) of profit comes from a small % of trades. 

If you dont at least recognise this in your trading your either *trading a consistent low R high* win rate method or you are actually cutting your winners short particularly if your struggling with profitability.

I even noticed on T/H's scatter chart he offered up some time ago that on that on his chart the above held true.

Its about always finding ways of improving your R/R so that your top 20% have the greatest impact on the bottom line.
Placing yourself CONSCIOUSLY in these positions give you more of an opportunity of being involved in a life changing trade---it only takes 1
A constant work in progress.

Its more than letting your winners run its setting yourself with a trading method which increases your opportunity of high R.

Lots of T/H's scatter charts here and discussion on the top small% higher winners and their effect on a trading method.

https://www.aussiestockforums.com/forums/showthread.php?t=12683&page=5


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## Trembling Hand (3 February 2010)

tech/a said:


> Easy to dismiss in a cursory manner if thats what you wish to do or believe.
> 
> I personally think there is more to it.
> Firstly its about observing and admitting that 80% (or a larger amount) of profit comes from a small % of trades.
> ...




Yes Tech I have acknowledged that the top 20% are the cream that makes the big diff. What you haven't acknowledged is that the bottom 80% of profits which is actually 80% of your effort pays your bills to keep the business going. You cannot survive without them.

I've done this game long enough to know what it actually takes to survive and prosper. And in my opinion far too many spend all their time chasing the prosper bit without taking care of the survive bit. I guess its a different perspective. I want to go to work and give myself the best chance at surviving and making money today, tomorrow and every day onwards, irrespective of what the market is offering.

I don't want to waste today chasing 20Rs, I want to work on being profitable on the 80% of the time that only 2Rs are on the table. Ironically the 10-20Rs will then be plentiful because I've profited when there was only 2Rs to get me through.

Thats why I scalp. Yet I will quickly bring out the trailing stop if warranted.


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## yonnie (3 February 2010)

do you treat 20R`s and 2R`s differently then?

I would have thought that both were traded in the same system and depending on the behaviour of that particular stock it will be whatever profit it wants to give; mostly 2R..........seldom 20R


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## krk004 (3 February 2010)

If one was to go back through the history of their trades and were to compare the 20% (giving 80% of profits) vs. the 80% (giving 20% of profits); ie set up, factors that came into making the trade etc.

And found that a particular aspect (condition or whatever) that was relevant & applicable to the 20% (earning 80% of profits), but not in the 80% (earning 20%).

Would you re-examine your trading methods?


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## It's Snake Pliskin (3 February 2010)

yonnie said:


> do you treat 20R`s and 2R`s differently then?
> 
> I would have thought that both were traded in the same system and depending on the behaviour of that particular stock it will be whatever profit it wants to give; mostly 2R..........seldom 20R



That's a good point which leads to my points of view. 

Opportunity cost is an issue which no-one seems to have touched on.  "Does one stop trading until specific conditions are met that lead to black swan events?" Why not take the opposite approach and be risk savvy and prepared for the b-swannies?


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## It's Snake Pliskin (3 February 2010)

skc said:


> I guess letting your profit run is in a sense applying the principle. Although it is a chicken and egg issue to me... i.e. Did you let profit run and so the results become 80/20, or did the 80/20 principle led you to let profit run?
> 
> I am a big fan of the Pareto principle - it is so useful in business planning, cost reduction etc. So it can be applied to the business aspect of trading to some extent. For example, a trader runs several strategies, each requiring roughly equal effort, but her returns are heavily skewed towards 1 or 2 strategies. Then the obvious answer is to concentrate only on those most profitable ones and forget about the less profitable ones.
> 
> The other one relates to trading costs. No point phoning around trying to get cheaper internet connection, when a phone call to your broker to get commission down a couple of notches will have a much larger effect...



I feel the principle is easier to apply to fields that are more concrete than the markets. TA spoke about contracts over a certain limit. That makes sense. How can you do that in the markets without the same 100% stipulated guarantee? 

For the markets it seems to be a way of analysing past results. I am happy to be corrected wrong.


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## Wysiwyg (3 February 2010)

It's Snake Pliskin said:


> Opportunity cost is an issue which no-one seems to have touched on. *"Does one stop trading until specific conditions are met that lead to black swan events?"* Why not take the opposite approach and be risk savvy and prepared for the b-swannies?




What this question says is you don't trade until before the black swan event. If you were short only then that would be a good strategy but aren't we discussing long too?


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## It's Snake Pliskin (3 February 2010)

Wysiwyg said:


> If you were short only then that would be a good strategy but aren't we discussing long too?




Yes, black swan events are impacts of the highly improbable. That is long too.


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## Wysiwyg (3 February 2010)

It's Snake Pliskin said:


> Yes, black swan events are impacts of the highly improbable. That is long too.




Ok I have deciphered. You either short the improbable black swan event or go long after the black swan event. That is a great strategy.


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## It's Snake Pliskin (3 February 2010)

Wysiwyg said:


> Ok I have deciphered. You either short the improbable black swan event or go long *after* the black swan event. That is a great strategy.



I would have thought being long or short during the event, not after it. That would require an entry prior to it.


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## Wysiwyg (3 February 2010)

It's Snake Pliskin said:


> I would have thought being long or short during the event, not after it. That would require an entry prior to it.



Yes, good idea.


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## yonnie (5 February 2010)

krk004 said:


> If one was to go back through the history of their trades and were to compare the 20% (giving 80% of profits) vs. the 80% (giving 20% of profits); ie set up, factors that came into making the trade etc. And found that a particular aspect (condition or whatever) that was relevant & applicable to the 20% (earning 80% of profits)




any idea what that particular aspect/condition might be?


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## krk004 (6 February 2010)

yonnie said:


> any idea what that particular aspect/condition might be?




For whom?

You would need to go over your own trading methods & results, analyse & see what you find.

In my case, adding a very simple 'filter' has improved my Win Loss ratio and decreased my ave loss % a bit.


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## yonnie (6 February 2010)

sorry I must have misunderstood you......

I thought you were looking for particular aspects/conditions in a stock that had a chance of ending up in the 20% group BEFORE the strong price rise happened.

you must be looking at the aspects/conditions DURING the big move.

correct me if I`m wrong


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## tech/a (6 February 2010)

Trembling Hand said:


> LOL tech you are a joke.
> 
> You are kidding yourself if you think that *you *actually apply Pareto principle.
> 
> You Don't Apply it. Its just the distribution of profit.




AND now seems many are attempting to apply the principal.



> sorry I must have misunderstood you......
> 
> I thought you were looking for particular aspects/conditions in a stock that had a chance of ending up in the 20% group BEFORE the strong price rise happened.
> 
> ...




Been pondering this for a few days.

I agree that in this instance application in a practical sence cant be done. The Pareto Principal is as you say a distribution of profit.

Everything we do in an attempt to increase our higher R winners is not application of Pareto.

I guess the application is the knowledge that our profit in most things we do will always be skewed by the big wins and if not up with risk management also by those big losses. Dramatically so.

So protecting against catastrophic loss and placing ourselves in front of opportunity arent applications of the principal itself but reactions to the *knowledge *of the principal.


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## krk004 (6 February 2010)

yonnie said:


> sorry I must have misunderstood you......
> 
> I thought you were looking for particular aspects/conditions in a stock that had a chance of ending up in the 20% group BEFORE the strong price rise happened.
> 
> ...





Not all my trades are winners, even with this 'filter'.

Can I provide a very simple (perhaps 'crude') example - say I trade Monday to Friday and after extensive search have found conclusive evidence (10+ years analysis) of which days provide my profit;

Monday - 80%
Tuesday - 30%
Wednesday - 20%
Thursday - (10%)
Friday - (20%)

Total - 100%

So I decide not to trade Thursday & Friday, result theoretical profit increase by 30% with 40% less effort.

Very simplistic, but in essence is what I am trying to convey.

So a filter that reduces my no. of losers, whilst still capturing the winners has made sense for me in my methods.


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## tech/a (6 February 2010)

Fine but you also find that on a Thursday/Friday you had a few trades which returned dramatically higher R multiple wins.
In fact those wins totalled nearly 40% of all your overall profits.
So you drop Thursday Friday?


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## yonnie (6 February 2010)

krk you must be daytrading then if taking trades on certain days is so important


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## krk004 (7 February 2010)

tech/a said:


> Fine but you also find that on a Thursday/Friday you had a few trades which returned dramatically higher R multiple wins.
> In fact those wins totalled nearly 40% of all your overall profits.
> So you drop Thursday Friday?




I did say it was a crude & simplistic example.

Perhaps I should have just said Indicator A, B, C, D & E. 

In a simplistic sense though, even with a couple of high R multiple trades with these providing 40% of profits, dropping Thursday & Friday made the overall system more profitable with less work.

Would you trade the 'Thursday & Friday' system as a stand-alone method with the previous results (even with some big R results)?

My original point was, using the Pareto principle in trading was about trying to identify what it was about the 20% effort (80% profit) that was different to the 80% effort (20% profit). Then seeing if there was a 'way' to spend more time with the former and less with the latter.

If you are making a profit with your own systems, what is making you that profit? Sheer luck or something else?


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## krk004 (7 February 2010)

yonnie said:


> krk you must be daytrading then if taking trades on certain days is so important




Yonnie, not a daytrader and certain days are not important to me, was just a simple & crude example.

Although I do remember reading some years ago where a successful trader (Mark Cook?? - not sure) cut out a day in his normal week of trading because of a similar reason to the example I used.

All the best.


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## yonnie (7 February 2010)

I`ve heard of non-trading days in forex or trading on certain hours of the day, when most of the trend/volume occur, like the start of the European/American session.

does that also happen in stock trading?


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