How to Use the 80/20 Rule in Trading

The Pareto Principle, commonly known as the 80/20 Rule, is often used in economics, statistics and by humorists to describe real life events and observations. Basically the principle says that 80% of an outcome can be achieved by 20% of the effort. The versatility of the Rule means that its applications can be almost endless but it’s amazing how accurate this Principle is. It can even be used to explain why so many traders struggle with their trading.

Anyone who’s been involved in trading for any time at all knows this principle to be true: that 20% of your trades inevitably account for 80% of your earnings. This leaves the other 80% of your trades, and most of your effort, to make up just 20% of your bottom line. So how can you, as a trader, better equip yourself to take advantage of that profitable 20%?

Here are a couple of key ways to incorporate the 80/20 Rule into your trading and hopefully increase your profits.

80% Winners

Do you think it’s a coincidence that markets trend 20% of the time and are choppy the other 80%? We know this to be true, yet few traders consider that it’s during the 20% Trending period when it’s also easiest to profit. Look at it this way: 80% of your profit will come from only 20% of your effort; therefore if the markets only trend 20% of the time, your best profit opportunities, 80% of them, will come during that 20% trending move. Therefore, as a trader, it’s to your advantage to find and capitalize on these trending moves. But how?

The simplest way to identify the overall market Trend is to take a broader view of the market. Just step back a bit. See what is happening in the market at a higher level. Very often traders become so engrossed on what the market is doing right now that they lose sight of the bigger picture, which often leads to taking losing trades against the trend.

Ed Seykota, one of the most profitable traders of modern times, trades this way. Seykota’s not concerned about picking the top or bottom in a move, and neither is he concerned about giving up some early profit. His focus is on finding the Trend and once he has identified the trend he keeps trading in that direction, usually with outstanding results. Although simple, it is a sound principle and one that you need to incorporate into your own trading as well.

While Seykota’s system for trend identification is rather simple, there are also technical methods for identifying trends through the use of indicators and/or trading systems. For example, the Eagle Trend Trader from IndicatorWarehouse.com is one such trading system, and one that I use to find and capitalize on emerging market trends. The Eagle was specifically designed to ignore short term price swings in favour of capturing larger, more profitable moves and only generates BUY/SELL signals when conditions are optimal for a trend.

Moving averages crossovers and channel breakout systems are also popular methods for determining market trends, but regardless of whether you use a system like DTS or something else, the important thing to remember is that it is worth your while to concentrate on finding and recognizing that 20% period when the market Trends. Your survival depends on it.

20% Losers

When you flip the Pareto Principle on its head, you find out that 20% of your losers are probably accounting for 80% of the drawdown against your account. The first order of business therefore, is to identify the source of the losses so you can get control on those trades that are putting a dent in your capital. I hate to have to tell you this, but it’s not the market’s fault you’re losing all that money – it’s yours. But there is good news.

The good news is that trades in this Big Drawdown category usually stem from only a few sources. These include:

  • overtrading,
  • strangling the trade (ie. stops too tight),
  • thrill or boredom trading, and
  • incorrect capitalization (ie. risking too much of your account per trade)

The bad news is correcting the problem requires a considerable devotion to trading discipline – something all traders pay lip-service too, but few actually do. However, once you begin to exercise some trading discipline and realize the rewards of not overtrading, or strangling your trade, or trading out of boredom, or not overcapitalizing your positions (ie. you make more money); the easier the changes become to make. In other words, taking the first step is the hard part.

But a word of caution: change can take a while. We’re all human and prone to make mistakes. I’ve been involved in trading for nearly 20 years and I still catch myself making some of these same mistakes from time to time. So be patient with yourself. But by knowing what you’re doing wrong you are one step closer to fixing the problem, even if you happen to slip up occasionally.

Remember the Objective

Keep your objective in mind. Remember that being choosy and holding out for the trades that fall within the 20% trending period will make earning a profit much easier. Remember too that flirting with the other 80% of the trades will barely pay for your efforts, so avoid them.

You might find, as many traders have, that will be trading less, but earning more; and as an added bonus you’ll be more in control of your trades too. In fact, you might find that your most profitable days will be the ones in which you have traded the least! Try Pareto’s Principle for yourself and see. The 80/20 Rule makes a lot of sense.

For more from Erich, visit the Indicator Warehouse for additional futures resources and NinjaTrader Indicators.