The Pareto Principle is one of the most popular management theories in the world. It was suggested by Joseph Juran, who identified a good relationship between 80% and 20%. Specifically, he noted that in most cases, the impact of a circumstance comes from 20% of action.
For example, in some companies, most of the revenue tend to come from a few customers. Today, the Pareto principle, also known as the 80/20 or 80-20 rule is applied in the stock and financial market.
In this report, we will look at the various ways in which you can use the principle to succeed as a trader.
80-20 rule in trading
The 80-20 rule is very common in the trading industry. For you as a trader, you might find that your most profits come from trading a single currency pair or stock. For trading companies, they might find that most of their profits come from 20% of their traders.
Similarly, companies may find that most of their income come from trading a specific asset class like stocks and cryptocurrencies.
The 80-20 rule can also be applied to the day or season of trading. For example, you may find that you make 80% of your income in the morning sessions or in the first half of the year.
It is worth noting that 80-20 is just the starting point. The ratio can change to 70-30 or 60-40.
How to use the 80-20 rule when trading
Come up with a trading strategy
If you are new to trading, we recommend that you take time to develop your trading strategy. You can check out our complete guide on developing a trading strategy to see how you can approach this.
As a newbie, we prefer that you use a demo account when creating and back-testing your strategy. As you do this, there are several strategies you can experiment. These are:
- Swing trading
- Trend following
- Using the Elliot wave
- Buying the dips and selling the rips
- Algorithmic trading
In 80-20 rule, you can find that most of your trading profits are coming from just one or two strategies. As such, you should focus on these strategies.
Assets you trade
Another way of using the 80-20 rule in trading is on the assets. A common mistake that many people make is to try and make money from everything.
This is wrong!
As you develop the 80/20 strategy, you can consider looking at all of your trades and identify the most profitable ones. These best-performers could be small-cap stocks, energy stocks, and even cryptocurrencies.
In this strategy, you should identify your best-performers and double down on them.
Time you trade
A good thing about the market is that you can trade it on a 24-hour basis. As such, you may find that most of your profits come during the American session followed by the European session. In the 80-20 rule, you should identify the one that makes more money and focus on it.
How to apply the 80-20 rule in trading
There are several approaches to apply the 80-20 rule in day trading. First, you can apply it to analyze your performance. In this, you should look at whether the majority of your losses are caused by the same strategy (or some of these factors).
Also, you can assess whether most of your losses are coming on certain days and whether they are coming from specific assets.
Second, you can look at the market when applying the 80-20 rule in trading. For example, you can note whether most of your winning trades are happening when you trade in a trending or ranging market.
Alternatively, you can check whether your profits are coming when you trade in the morning or afternoon session.
Third, you can apply the 80-20 rule to analyze strategies. At times, you will find that just a few strategies that you use are generating most of your profits.
In this, you can also look at the types of orders that you enrer and whether a small group of indicators are responsible for your profits.
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Building a strategy using the 80-20 rule
The 80-20 rule is itself not a trading strategy. However, it is possible for a trader to come up with a strategy by carefully journalizing the answers mentioned above and then finding the best practices.
For example, a trader can list his best practices and then identify those approaches that work well. If you are a full-time trader and you realize that most of your profits come when you trade in the morning, then you can put more effort to that.
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Further, if you realize that you make more money when using just the VWAP indicator, then you can give up on the rest.
By going through this checklist, you will be at a good position to come up with a narrow and focused strategy that works well and then avoid what does not work.
You can also use the same approach when coming up with an investing strategy. In this, you can identify that most of your best investments come from the tech sector. As such, you can narrow your investments from other industries like finance and energy.
The 80-20 rule is an important concept on virtually all fields. For example, we have seen companies sell their underperforming businesses as they try to refocus on the segments that work.
You can do this too as a trader.
You can identify the things and double down on them. By so doing, you will be at a good position to sharpen your trading skills and become a better trader without being crazy.