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Trading The Pareto Principle

This year we have focused several Elite Trader Training Sessions on the topic of Asset Allocation Modeling, in addition to drawing comparisons with personality profile assessments. Being able to assign a specific trade/strategy to a quadrant model for allocation percentage based on the risk, reward, and probability profile, is yet another way to minimize emotional involvement in the allocation decision.


With that in mind, there was an Italian economist back in 1906 who observed some very interesting relationships. His name was Vilfredo Pareto, and is credited for creating what is referred to as the Pareto Principle. It is also known as the “80-20 Rule”, the “Law of the Vital Few”, and the “Principle of Factor Sparsity”. In short, this principle states that for many events, roughly 80% of the effects come from 20% of the causes. He initially developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas, and later observed that 80% of the land in Italy was owned by 20% of the population.


This has become a common rule of thumb in business, and distribution of income and wealth in an economy. In business, it is often said that “80% of your sales come from 20% of your clients”. Further, “80% of your sales will be generated by 20% of your sales force”. This relationship exists in a variety of economic categories and subsets. Since healthcare is a popular topic as of late (or unpopular dependent upon your perspective), you may find it interesting to know that in the United States 20% of patients have been found to use 80% of health care resources. How about criminology? 80% of crimes are committed by 20% of criminals.


Of course, this relationship is very evident in the stock market as well. In fact, 80% of your profits come from 20% of the time you spend. Think about this for a minute - 20% of the time you spend is responsible for 80% of your success.  It's not a coincidence that 80% of a trader's success relies on an individual’s ability to maximize analytical efficiency, while minimizing emotionally driven inefficiency. The key is working diligently to pinpoint that 20% period where your success lies, and to do so removing elements of the 80% time wasted along the way.


This is the exact intent/purpose of everything we do here at ETNtrade: Constantly revisiting models and methodology for efficiency, productivity, and at the end of the day the most important measure – profitability. The bottom line: the MENTAL process involved in executing a trading plan will largely dictate your results.  Self-awareness of personality traits is often the "missing link" to consistent results.  In fact, studies show it is responsible for 80% of your result! 


Fundamental or Technical Analysis: Which Is More Important?

When sitting down to trade, a lot of decisions need to be made.  The question often arises:  What type of analysis should I use, and in what order?  Not only do you need to decide when to trade, but equally important is what blend of fundamental and technical analysis to use.  If there are flaws in how you perform this analysis, or your indicators aren’t setup properly, the analysis will render poor results.  How do you prevent these mistakes?

First, let’s start with some foundation. Fundamental traders evaluate information on the company balance sheet, P/E, earnings, etc. Fundamental traders anticipate the stock price will move in a direction that coincides with the economic standing of the company the stock represents. Many times I have been watching the market during a report or earnings release, and the stock reacted in the complete opposite direction of the good or bad news. You may ask yourself: How is that possible? It is actually very common, and can be a result of profit taking, beating expectations but missing on guidance (or vice versa), an overriding market event or news, and frankly sometimes it can’t really be explained with logic and reason. After all, we are talking about the stock market, right?

Now, Technical traders are viewing the market from a very different perspective. This doesn’t mean Technical Analysis eliminates the decoupling of logic and reason, but in many cases it will give you a clear picture of fulfillment. The question that often circulates is: Do Fundamentals dictate Technicals, or is it the other way around? In reality, it’s not the right question to ask, as they both play an equally important role. The point that needs to be understood is that Technicals always fulfill, even in cases where new patterns emerge. Fundamental news is simply a means to accelerate this fulfillment.  

A Technical trader will look predominately at the charts and inspect them for multiple patterns. The most common styles involve support and resistance. A deeper understanding in this arena alone will give you an entirely new view of the market and the candidates you trade. When you learn to trade using Japanese Candlesticks, and you understand the various terms and patterns, you will be able to get an even better perception of what is going on in the market. Fibonacci analysis is also very popular in our Live Trading Sessions, so of course we focus here as well.

Here is the Golden Ticket: In the Options Market we do not have to commit to a direction. In fact, we have complete control of very finite moves and reactions. We can be completely non-directional, or position ourselves in a non-directional trade that carries directional bias. In doing so, we remove the risk the stock trader carries, as they have to pick 1 direction and hope. We do not base our positions on hope; we base our positions on Statistical Probability, Fundamental Analysis, Technical Analysis, and Option Chain Analysis. The wonderful part to all of this is that we have a very easy to follow methodology, and a track record of success to prove its worthiness. The only requirement from you is dedicating the time to learn it, practice it, and apply it. Our members are doing exactly that with us everyday… and we have FUN every step of the way!

In short, the best traders on this planet have a solid understanding of both Fundamental and Technical Analysis. This dynamic combination will give you a strong foundation for direction and anticipated price action of the stock you are trading. It’s the only thing a serious trader can ask for. An Edge in trading is powerful, and can be all the difference between success and failure in the market.

Federal Reserve Monetary Policy: Head On A Swivel!

Since football season is right around the corner (Hooray!), it made me think about a football phrase familiar to all that have played defense or special teams – Keep your head on a swivel! It only takes one experience of getting upended by a rival player that you never saw coming to take these words to heart. The point is that you always have to be aware of your surroundings, your assignment for the play, and who might be head-hunting you on the opposing team… Keep your head on a swivel!


I think this phrase has become very relevant in the current market, and here’s why: It’s easy to be lulled into a state of partial complacency as the market seems to continue to churn higher. The talking heads are excited about the trend, as it makes their job that much easier when we are in a directional trend. However, when this hypnotic discussion begins to become digested as the gospel, the red flags should start to rise.


Let’s take a few moments and discuss several reasons why you should keep your head on a swivel in the market right now. For starters, “the Bernank” and Fed monetary policy. We’re all well aware that the printing presses have been in turbo mode for quite some time, but the concept of “QE Infinity” simply can’t sustain. We’ve received a few hints over the past few months that even Mr. Bernanke is coming to terms with this fact, as there has been more emphasis on the cost associated with this easy monetary policy. On May 22, it was made clear we are likely to see the printing presses start to taper down much sooner than what has been expressed in the prior months/years. The Fed's policy-setting Federal Open Market Committee started a two-day meeting Tuesday and the markets have their ear to the wall with a water glass as traders try to anticipate the Fed's timeline for winding down a bond-buying program that has been fundamental for price moves in various markets. There is no question that the moment the presses officially slow the market will be tested. Are you prepared for a correction as we speak? If the answer is no, do you think it would be wise to consider insulating your portfolio?


Another twist that could rattle the markets is the possibility of Mr. Bernanke stepping down, or being replaced by President Obama. In fact, there were hints of such action expressed during an interview with Charlie Rose on Monday. Though Obama was fairly vague when asked point blank if he would reappoint Bernanke if he wanted to stay at the post, you can read between the lines with regard to intent: "He has been an outstanding partner, along with the White House, in helping us recover much stronger than, for example, our European partners, from what could have been an economic crisis of epic proportions," Obama said. But again, what is the plan for Bernanke? "Well, I think Ben Bernanke's done an outstanding job. Ben Bernanke's a little bit like Bob Mueller, the head of the FBI - where he's already stayed a lot longer than he wanted or he was supposed to," Obama said.


It sounds like President Obama is indeed looking for a new chief of the U.S. Federal Reserve Bank. In fact, Obama is said to be considering a number of monetary experts for the job, including Fed Vice Chair Janet Yellen, former U.S. Treasury Secretary Lawrence Summers, and former Treasury Secretary Timothy Geithner. An announcement could come as early as this fall, to give the Fed nominee time to get through Senate confirmation by the time Bernanke's term ends. Buckle your seatbelts for the remainder of 2013, as we could see some intense daily swings as we test taking off the “training wheels”. Keep your head on a swivel, prepare your portfolio now, and let’s enjoy another wonderful season of football!


Hybrid & Synthetic Strategies - Sound Complicated?

Not to fear, hybrid strategies are actually very easy to understand - if you have a reliable and credible source to learn.  Misinformation is prevalent on the internet, so you have to vet your sources carefully.  For traders on the lower end of the market education curve, options are "risky" and "dangerous".  Yet, by definition options were created to mitigate risk.  So, isn't it really about perspective?

Think about it this way - If you don't know how to drive a car, should you jump into the driver's seat of a stock car for a few test laps?  If you did, would it be fair to yell at the car when you slide into the wall on turn #1?  It's kind of funny to consider it, but it's so very true.  The machine didn't fail, the operator did.  The same holds true in the options market.  The vehicle isn't to blame for success/failure, as it is up to the operator’s competency.  The options market is abound with advantages to win the race, and with much greater safety.

This is where Hybrid and Synthetic Strategies give a trader or investor an extra "turbo-boost" to win the race consistently.  A hybrid strategy is nothing more than a variation of an existing option strategy.  No more, no less.  A simple tweak to an expiration date or strike price choice can create this 'hybrid' variable.  Doesn't sound quite as mystical now, does it?  Nothing is, when you fully understand its purpose!

A synthetic strategy incorporates stock ownership.  That's it.  When you hear "synthetic" think stock ownership first, options position second, because that is exactly what it is.  As an example, if you hear someone talk about a synthetic call, all you need to know (for starters) is that the individual owns the stock.  Then, it's simply a matter of understanding whether they are buying or selling calls or puts in addition to that ownership.  Why would someone do this?  Drum roll please... to LESSEN the RISK of owning the stock.  Options defined yet again.  By the way, a synthetic call is the same thing as buying a put to protect downside, or a "married put" as some have coined it.  How about those Covered Calls that are often touted as being so very “safe"?  Did you know a covered call is actually a synthetic NAKED PUT?  This is a fact, and based in this fact, does it still sound so safe?  I hope this has gotten your wheels turning, because it is very important information to have in your back pocket at all times.

In short, the most complex concepts in the market can be easily understood and digested if you have the RIGHT SOURCE to explain it to you, using a step by step process.  This is the ETNtrade advantage.  A general working knowledge is the best most traders ever achieve, and it's also the most dangerous combination in existence for failure.  Think about the most successful traders you have ever heard of.  Were any of them "kind of" educated and "sort of" experienced when they started drawing so much attention for their consistent success?  That being said, how quickly do you want to get there for yourself?  This is another ETNtrade Advantage - efficient, thorough, disciplined and consistent.  Are you ready to get where you want to go?  We're ready, and our tools are at your disposal.

Probability - How Do You Quantify It?

Countless times over the years I have heard traders refer to the 'probability' in a trade, with little or no supporting evidence for the statement other than it sounds good.  By definition probability is the likelihood that a specific event/action/outcome will take place within a given time frame.  This is very helpful information to have.  In fact, it is absolutely critical information to be able to calculate mathematically as a trader.

For example, you have a trade that carries 80 percent probability of success.  Is this good in itself, or do we need more information?  What if this 80 percent probability is in a trade where you will make 200 dollars if you are correct, lose 800 dollars if you are not?  Is this good or bad?  It's actually neither, because it is "statistically" in line.  8 out of 10 times you will win 200 (8 x 200 = 1,600), and 2 of 10 times you will lose 80 (2 x 80 = 1,600).  The net effect is you end up where you started... break even.  This is the true purpose of probability discussions, not a random assignment of a percentage to a tradable opportunity.

So, let's change the example and see if we can create a 'better' scenario - You have 80 percent probability for success, and it yields 400 in gain when right, 600 in loss when you're not.  Is this a good probability scenario, statistically speaking?  The answer is YES.  If we win 8 of 10 times and lose 2 of the 10 times, our net is 2,000 in gain.  Is this a more favorable 'probability' than the first example?  Absolutely!  Again, this is the true purpose of probability analysis.

Do you follow this type of process in your current trade analysis?  If not, why?  Is it because you don't know how to do this, or maybe you weren't aware that you could?  You ABSOLUTELY CAN.  This isn't even the exciting part.  Probability is much deeper than this in the Options Market.  Not only can we calculate mathematical or 'target' probability, we can calculate the ACTUAL probability of our trades based on risk/reward and target probability.

This is yet another advantage professional traders are using every single day against those that are less educated.  Would you be interested in learning this mathematical advantage for your own profitability?  Do you think this one advantage alone would help your consistency immediately?

Would you like to learn more insight like this from active traders?  These discussions and lessons are being taught every single day at ETNtrade.


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