Applying the 80-20 Rule to Forex and CFD Trading

May 06, 2017 05:30

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Dear Traders,

Have you ever heard about the 80-20 rule but wonder how it could help you with achieving better results with Forex, CFD, and commodities trading?

This article discusses how you can apply the simple logic of 80-20, which indicates that 20% of the input and effort will create 80% of the output or success.

Sounds simple, right?

It is a very effective tool in improving one's trading performance and other aspects of business and life, too. I will explain exactly what the 80-20 rule means, why it is effective, and how to apply it to your trading,

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What is the 80/20 Rule?

The 80/20 Rule states that a small amount (minority) of your effort will create and lead to most (majority) of your success.

For instance, in business 20% of the customers might lead to 80% of the revenues. In trading, 20% of the losing trade setups might cause 80% of the losses.

The 80/20 Rule was discovered in 1896 by the Italian economist Vilfredo Pareto, which is why the Rule is also called the Pareto Law, the Pareto Principle, and the 80/20 Principle. Pareto discovered the odd balance when he examined that 20% of his peapods contained 80% of the peas.

Are the numbers always 80/20?

No, the 80/20 numbers are just an example used to illustrate this odd relationship between small and large. In reality the numbers can vary from case to case but the main characteristic is that they are unbalanced and far off from 50/50.

For instance, an ice cream shop might get 60% of its profits from 15% of its regular customers. This is also a valid example of the 80/20 Rule at work.

Traders and people in general tend to believe that each unit of effort or resource has (almost) an equal relevance for success. However, the 80/20 Principle bursts this bubble and shows that the numbers are highly skewed.

According to author Richard Koch who wrote the book 80/20 Principle, probability theory explains that it is "virtually impossible […] for the 80/20 Principle to occur randomly." (*)

What can the 80/20 Rule actually measure?

Simply said, 20% (or equivalent) of the work or input will create 80% (or equivalent) of the success or output.

The work or input could be anything: resources, time, investment, effort, or skill in general, and your winners, losses, trades, or strategies for trading specifically.

The success or output can also be various: profit, revenue, mistakes, membership, customers, and ratings in general and for trading.

Here are a few more practical examples:

  1. 20% of the peapods contain 80% of the peas (discovered by Pareto himself)
  2. 33% of your hobbies will demand 90% of your time
  3. 10% of tasks at work lead to 70% of your career achievement
  4. 25% of your mistakes when trading lead to 75% of your losses
  5. 20% of our the books can deliver 90% of new wisdom (see image below)

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How do I actually use the 80/20 Rule for my trading?

As a trader it is a critical and key concept to analyse your trading, your performance, your statistics, your evaluations, analysis, your trade setups and more. Simply said, it is an all round tool for analysing your trading business.

When I review my trading, stats, and evaluations, the 80/20 Rule is on the top of my mind because this is an excellent method for improving efficiency.

Here are three ways how the 80/20 Rule has propelled my trading.

1. Trading performance.

The 80/20 Rule can improve your trading performance. It did for me: for instance, I discovered that two mistakes were causing a majority of my trading losses. One of the mistakes was zooming into lower time frames and fearing irrelevant price action at the start of a trade.

Traders should check all of the aspects and more:

  • Which parts of the trading plan impact losses and wins?
  • Which tools, indicators, and strategies are causing the most losses and wins?
  • Which time of the day or day of the week or month are impact your stats?
  • Which error types have a disproportionate impact?
  • Which filters have very small or very large impact on the performance?
  • Which losses and wins are triggered by the same entry type or trading system?

2. Individual performance.

The 80/20 Rule can improve your own efficiency. For instance, I noticed that a majority of attention span was distracted by email and Skype, which I now turn off regularly to improve focus on trading and writing this article.

Things to keep an eye on are:

  • How much time and resources are spent on a task and why?
  • What actions, behavior, and ideas lead to the most benefit?
  • What kind of benefit does the task deliver and does it justify the time and resources?

3. Market understanding.

The 80/20 Rule can improve your understanding of how the financial markets and price action behave. In my view the market tends to relate closely to the 80/20 Rule in the following ways:

  • Price action is ranging or trending 80% of the time whereas 20% (or less) of the time price action is forming a top or bottom.
    Key lesson: be cautious with expecting reversals.
  • Price action is behaving correctively 80% of the time whereas 20% of the time it is moving with impulse or momentum.
    Key lesson: momentum bursts typically last short.
  • Price action is not at an interesting spot on the chart 80% of the time whereas 20% of the time price action is at an interesting spot.
    Key lesson: be patient with waiting for the right trade setup.

Applying 80/20 to forward thinking

The 80/20 Rule is in a certain way related to Chaos Theory, which explains that below the apparent randomness of chaotic complex systems there are underlying patterns, fractals, and repetition.

The 80/20 Rule is fractal of nature too, because the same rule can be applied over and over again (repetitively).

  1. For instance, 15% of the customers can deliver 75% of the revenue. But when we use the same 80/20 Rule again for the second time, then we might conclude that 70% of the earlier mentioned group of 15% were approached by one member of the sales team (something he or she did was very valuable).
  2. In trading for example, a trader might conclude that 70% of the total losses might be based on 25% of ill trade management decisions. The second attempt to apply the 80/20 Rule could indicate that the 85% of the bad trade management decisions occur to setting up unrealistic targets.

The 80/20 Rule is analysis and offers a backward look and view. It is trying to learn from the past.

The 80/20 thinking is a mindset that is forward-looking. Once you know the rule, you can apply and learn from the concept either immediately or relatively soon.

The 80/20 Rule and thinking allows you to cut your losses and focus on your winner quicker. This is exactly the winning formula needed in trading: cut your losses short and let your winners run.

The 80/20 approach is a practical method that allows you to do just that: search for patterns that you would otherwise miss and cut short losses, behaviors and ideas that would keep going for months or even years.

One of the elements that will always benefit your trading are the 60+ extra plugins from MT4 Supreme Edition ranging from an indicator package to trade-terminal to trading simulator.

Cheers and safe trading,

Chris
Follow @ChrisSvorcik on twitter for latest market updates

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(*) Page 13 in the 80/20 Principle: the Secret to Achieving More with Less by Richard Koch, 1999, published by Crown Business.