The Profit Distribution in Trading

By | January 1, 2016

I recently finished reading the book Trading Risk: Enhanced Profitability through Risk Control by Kenneth Grant. It’s not an easy read, and several times I was reminded of this paragraph from Michael Marcus’ interview in Market Wizards:

For almost two years, I traded almost nothing but cocoa, because of the information and help I got from Helmut Weymar [the founder of Commodities Corporation]. Helmut was an incredible expert on cocoa. He wrote a book that was so deep I couldn’t understand the cover.

But hey, the author has managed portfolio risk for several of the world’s most elite traders, including Steve Cohen and Paul Tudor Jones, so he’s definitely a guy worth listening to.

One of the points made in the book, which I’m sure will come as a surprise to many, is about the 90/10 profitability concentration ratio. What this means: Ken Grant analyzed the trades from a large sample of portfolio managers (and remember, we’re talking real professionals here) and found that for nearly every account, the top 10% of all transactions ranked by profitability accounted for 100% of the P/L for the account. In many cases, the 100% threshold was crossed at 5% or lower. Furthermore, this pattern of profit distribution was consistent across trading styles, asset classes, instrument classes, and market conditions.

This reminded me of a paragraph from Pit Bull, written by Market Wizard Marty Schwartz:

For two hundred days a year, I’d end up with reasonably small losses netted out with similar-sized gains. Lose $5,000 here, make $6,000 there, round after round, twenty, thirty, forty times a day. But I’d win the other fifty trading days by clear-cut unanimous decisions.

Ok, so we now have proof positive that a modified or extreme form of the Pareto principle is present in trading. What are the implications of being aware that 9 out of every 10 trades you make are likely to aggregate to produce profits of exactly zero? Ken Grant says that most people will view it as a problem that needs correcting (ie, by reducing the number of trades, or in forum speak, take only A+ setups). And they would be wrong. The reality is that we need the 90 trades that amount to nothing in order to get the 10 really profitable ones. Why? Because it is impossible for a trader to know in advance which trades are going to work for big returns and which are not.

Of course, we should only enter trades expecting to make money on them, but also be conscious of the fact that most of these trades won’t contribute appreciably to our bottom line. Consequently, we want to be in a situation to capitalize maximally on the 10% (for instance by letting the profit run or pyramiding) while ensuring that the trades in the 90% category won’t cause serious damage. And how do we do that? By keeping the risk per trade constant (0.5% for instance) in relation to account equity.

Awareness of the 90/10 rule will also help us in better understanding and accepting the realities of trading. As any experienced trader knows, you go through weeks and months of difficulties in the markets before ultimately scoring meaningful gains. In these intervals, you might assume that the core fundamentals of your strategy have broken down and that drastic changes are needed. It’s important during these moments to remember two things: first, that even the best traders are subject to profitability concentration and therefore they often have extended periods of underperformance. Second, that the markets do not offer large profit opportunities on a routine and continuous basis.

Provided that you can effectively apply risk management, time is on your side during these dry spells because over the longer haul, the market is bound to offer enough occasions from the 10% category.