Pareto principle – The 80/20 rule.
The 80/20 rule is one of the principles I trade by. No matter what your area of specialty is, you’ve probably heard about the “Pareto principle” or the “80/20 rule”.
It is applied in business studies, sales, economy and many other endeavors. Here’s how the 80-20 rule can help optimize your trading and boost your trading profits.
Wikipedia defines the Pareto principle as a principle which states that, for many events, roughly 80% of the effects come from 20% of the causes.
For example, in business – where it is considered a very important rule: 80% of your sales come from 20% of your clients.
The origin of this principle came from an Italian economist named Vilfredo Pareto who observed in 1906 that 80% Italy’s land was owned by 20% of the population.
There is an unlimited number of areas where the Pareto principle. Some people even apply it to their lives as human beings.
Blogger Yaro Starak has a great post about how the 80/20 rule can change your life, and author Richard Koch wrote a book about living by this rule.
If 80% of your trading profits comes from 20% of your transactions, these 20% have to be the large winners, or what is commonly referred to as “trends”.
To prove this point, assuming that you executed all the trades the system signaled, there will be four types of outcomes:
Small losses (which will happen in any system and are costs of doing trading business)
Large losses (which should be in the small losses category as long you use a stop loss).
If you sum those up, what happens is the small winners and the small losses will balance each other out, and you’re mostly left with the large winners.
This way the large wins will make more than 80% of your trading account profits.
So how do we catch the large winners?
Use profit targets far enough to cover at least 2 to 3 times your stop-loss value. This will increase the probability of catching big moves in the market.
A little back testing work can help you determine the optimum profits target value.
Trading losses can’t be avoided; they are just part of the business. Anyone who tells you otherwise is not being honest. I’ve never seen a real trader who doesn’t lose money from time to time.
The good news however, is we can minimize them. Using the Pareto efficiency principle, our target is eliminating the few behaviors that contribute to more than 80% of the trading losses.
Those behaviors can be the few that “happen occasionally” and traders don’t pay much attention to them. They are typically: chasing entry levels, day-trading in volatile times such as
important news release times and acting on trading impulses or emotions. Get rid of those, and you’ve eliminated just about 80% of your trading losses.
Trading is the ultimate “less is more” profession, but it’s also extremely difficult for most people to come to grips with this fact by accepting the following:
80% of trading should be simple and without stress, 20% is more difficult.
80% of profits come from 20% of trades. 80% of the time the market is not worth trading, 20% of the time you should find low risk trading opportunities. 80% of the time you should not be in a trade, 20% you can be.
80% of trades should be on the daily chart time frame, 20% can be other time frames. 80% of trading success is a direct result of trading psychology and money management, 20% is from strategy / system.
Let’s delve into each of the above points a little deeper and see how you can start applying them to your trading, and hopefully start improving it, significantly.
80% Simple, 20% Difficult
This one is easy. Most of what we do as traders is sit in front of our computers and look at prices going up or down or sideways; determining market direction and finding trades is not hard,
people make it hard.
The difficult part of trading is controlling yourself and not over-trading, not risking too much per trade, not jumping back into the market on emotion after a big win or a loss, etc.
In short, controlling your own behavior and mindset, as well as properly managing your money are the hardest parts of trading, and traders tend to spend less of their time & focus on these more difficult aspects of trading,
probably about 20%, when they should be spending about 80% of their time on them.
80% of profits come from 20% of trades
We absolutely must wait patiently for high-probability trade setups, rather than the high-frequency trading style that tends to put so many traders ‘out of business’. I
t’s absolutely true that most of my trading profits come from a small percentage of my trades.
80% of the time I am not trading, 20% of the time I ‘might’ be. I don’t like to risk money on a setup that isn’t ‘screaming’ at me or what I like to say is “damn obvious”.
Most traders like to trade a higher-frequency trading style, and it’s not a coincidence that somewhere around 80 to 90% of them lose money.
They are losing money because they are trading way too much and not being patient or disciplined enough to wait for their strategy to really come together and give them a high-probability entry signal.
”You don’t need to trade often. If you can catch one or two moves to the targets during the day with good size, you can make a good living and keep trading costs down.”
Do you see the connection between the fact that most traders lose money (around 80%) and about the same amount of time the market is really not worth trading?
Markets chop around a lot, and a lot of the time the price action is simply meaningless. As a price action trader, our job is to analyze the price action and have the discipline to not trade during the
choppy (meaningless) price action and wait for the 20% or so market conditions that are worth trading.
The main thing that separates the professionals from the amateurs in this business is patience and not over-trading. Traders tend to negate their trading edge by trading during the 80% of the time
when the market is not worth trading. Instead of waiting for the 20% of the time when it is worth trading, they simply trade 80% to 100% of the time with very little discretion or self-control,
like a drunk guy at a casino.
Don’t let this be you, remember the 80/20 rule ESPECIALLY as it pertains to trading vs. not trading. If you think you are trading about 80% of the time, you need to evaluate your trading habits and
make it more in-line with trading only 20% of the time and 80% of the time should be spent observing and keeping your hands in your pockets (not trading).