Have you ever noticed that most of the money in the world is held by a relatively small minority of people? Or, how about that most people tend to work in short spurts of intense productivity followed by larger periods where they are less productive? There’s an underlying principle that can be used to describe such occurrences, it’s known as the Pareto principle, or the ’80/20 Rule’.
Some of you might be familiar with the ‘80/20 Rule’, some of you might not be. For those of you who haven’t heard of it before or need a refresher, according to Wikipedia, “it is named after Italian economist Vilfredo Pareto, who observed in 1906 that 80% of the land in Italy was owned by 20% of the population; he developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas”
The 80/20 rule is popular in business studies, sales, economics and many other fields. However, today we are going to discuss how the 80/20 rule applies to trading and the significant positive impact the “80/20 mentality” can have on your trading performance.
How the 80/20 rule applies to your trading
Quick note: These are my personal observations over my 10+ years in the market. The 80/20 rule is not an ‘exact’ science, but it does give you a very effective way to make sense of many aspects of trading and how they all fit together. Also, all ‘80/20’ ratios discussed below should be thought of as “approximate” ratios, meaning they could actually be 75/25 or 90/10, etc.
As Yaro Starak points out in his blog post on the 80/20 Rule and Why It Will Change Your Life:
“By the numbers it means that 80 percent of your outcomes come from 20 percent of your inputs. As Pareto demonstrated with his research this “rule” holds true, in a very rough sense, to an 80/20 ratio, however in many cases the ratio can be a lot higher – 99/1 may be closer to reality.”
I wanted to start off with the above quote by Yaro Starak because in trading, the 80/20 rule is more like 90/10 or sometimes even 99/1 as he says.
How often have you heard “90% of traders fail while only about 10% make consistent money”? Often, I am willing to bet. Whilst the exact ratio of traders who make money vs. those who lose money is obviously almost impossible to pinpoint, it probably is somewhere between 80/20 and 95/5. Have you ever thought to yourself “why is trading apparently so difficult that 80 or 90% of people fail at it?” I’m willing to bet you have, and here is my answer to this pervasive question:
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 almost effortless, 20% is more difficult
- 80% of profits come from 20% of trades
- 80% of the time the market is not worth trading, 20% it is
- 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. This is not by anyone’s standards “hard” to do. Hell, you can put a 5 year old in front of a chart and ask them which direction they think it will go next and they will probably get it right more often than not. The point is this; determining market direction and finding trades is not hard, people make it hard.
I teach price action as you probably know (honestly, if you don’t know that by now you need to checkout this article right now: price action trading introduction), and it’s not simply some strange coincidence that I teach this particular form of trading, I also personally trade with price action…because it is simple (and effective). The trading strategy you use doesn’t need to involve complex computer algorithms, counting ‘waves’ or interpreting heaps of indicators. In fact, most traders get bogged down with trying every trading method under the sun until they either give up or figure out that they were simply over-complicating what should be a very simple process.
The difficult part of trading is controlling yourself via 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
If you have followed my blog for a while, you know that I am strong proponent of “sniper trading” and waiting patiently for high-probability trade setups, rather than the high-frequency trading style that tends to put so many traders ‘out of business’, so to speak.
It’s absolutely true that most of my trading profits come from a small percentage of my trades. I like to keep all my losing trades contained below a certain 1R dollar value that I am comfortable with, and if I see what I consider an “obvious” price action signal with a lot of confluence behind it, I will go in strong and make a nice chunk of change on the trade if it goes in my favor. Because I trade with such patience and precision, the winning trades I have typically double or triple the 1R risk I gave up on any of my losers. This way, even if I lose more trades than I win, I can still make a very nice return at year’s end.
80% of the time I am not trading, 20% of the time I ‘might’ be
I might trade 4 times per month on average, quite simply because I am a very picky trader. 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.
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.
This point is the most important in this whole article: I get a lot of emails from beginning and struggling traders and I know for a fact that 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).
80% daily chart trades, 20% other time frames
The daily chart time frame is my “weapon of choice” as far as chart time frames are concerned. I would say it’s pretty accurate that just about 80% of my trades are taken on the daily chart time frame. I won’t get into all the reasons about why focusing on the daily charts is so much better than lower time frames, but you can click the link above to find out more.
However, I would like to point out that there is also a direct connection between the fact that most traders get caught up trading lower time frame charts and most of them lose money. This fits well with the 80/20 rule in that probably only about 20% of traders really focus on higher time frame charts like the daily chart and somewhere around 20% to 10% of traders actually make consistent money. People tend to be drawn to the “play by play” action on the lower time frame charts, almost like they are mesmerized by the moving numbers and flashing colors…unfortunately, this turns into somewhat of a trading addiction for many traders, that quickly destroys their trading accounts.
80% of trading success is psychology and money management, 20% is strategy
In the article I wrote that detailed a case study of random entry and risk reward, I showed how it is possible to make money simply through the power of money management and risk reward. To be clear, I was not and am not saying that you can make a full-time living as a trader without an effective trading strategy. I am simply saying that money management and controlling your mindset is far more important than finding some “perfect, Holy-Grail” trading system that simply does not exist.
You should be focusing about 80% of your trading efforts on money management and controlling yourself / being disciplined (psychology), and about 20% on actually analyzing the charts and trading. If you do this consistently, I can guarantee you that you will see a very positive change in your trading profits, or lack thereof.
Using an effective trading method that is also easy to understand and implement will give you the mental clarity and time to focus 80% on money management and discipline whilst only needing about 20% of your mental energy for analyzing the markets and finding trades. A lot of traders never even get to this point because they are still trying to figure out how the heck to make sense of their trading system.
Where to go from here with the 80/20 rule…
If you look back over your trading account history from January 1st until now, ask yourself how many of the trades you lost money on where actually valid occurrences of your trading strategy (edge) versus random gambling-type trades that you entered out of emotion or impulse. I’m willing to be that the ratio of emotional trading losses to losses that were the result of a normal statistical losing trade, is about 80/20…surprise, surprise.
The implication here is clearly that you can eliminate about 80% of your trading losses by avoiding emotional or impulsive trading. The first step to trading with an ‘80/20 mindset’ is to master a simple trading strategy like the price action strategies I teach in my trading courses. As I said earlier, if you do this it will give you the foundation you need to focus more of your time on the real “money makers” in trading, which are money management and your own mental state. Thus, the 80/20 rule in trading is best applied by combining a simple trading strategy and a strong focus on money management and psychology, the synergy of this combination is a very potent force for making money in the market.