Applying the 80/20 Rule in Trading

The 80/20 rule or, as it is popularly known in the scientific community, the Pareto Principle, is a way to maximise efficiency in trading. Initially used by the Italian economist Vilfredo Pareto, the principle claimed that 20% of the population in that country owned 80% of the land in the country. Over time, the rule started being applied to other aspects of life. This rule has also been expanded to the complete economy of nations, where 80% of the wealth is controlled by 20% of people. Let’s look at how this applies to trading in the global financial markets. 

Interpreting the 80/20 Rule for Trading

The 80/20 rule has been changed a little since its origin, so that it can be easily applied to business. It claims that 80% of the outcomes of any activity originate from 20% of the actions. The Pareto principle finds applications in nearly all aspects of trading, including assessing the state of the economy, allocating funds to various asset classes, and portfolio diversification. 

In simpler terms, some traders believe that 80% of profits come from 20% of trades. Others believe that 80% of losses can be traced to 20% of wrong trades.

The Pareto Principle applies to the US markets as well, which means about 80% of the US stock market capitalisation is concentrated in 20% of the top S&P500 stocks. The rule applies to almost everything.

Applying the 80/20 Rule in Day Trading Strategy

While developing your day trading strategy, here are some ways to apply the 80/20 rule:

Choosing a Trading Strategy

You can explore market opportunities with a variety of trading strategies, including scalping, swing trading, trend following, Elliot wave, algorithmic trading, and copy trading. A common practice is to identify around 20% of these techniques and focus 80% of your account on them. As beginners, identifying these and focusing on refining them could help you create a strategy that largely works for you. 

Picking the Most Suitable Assets to Trade

There is no dearth of opportunities in the global financial markets. But trying to place trades at every opportunity may leave you exhausted. This may also lead to burnout, as you undertake overwhelming levels of market analysis and make decisions in fast-paced markets. Your gains may not even match the efforts you put in. According to the 80/20 rule, you can optimise your efforts. A better way is to look for 20% of assets that will make up 80% of your trades. These could be indices, small-cap stocks, forex, or even cryptocurrencies. You may choose the assets according to your trading goals and risk-taking capacity. This also helps you identify your strengths and weaknesses and helps refine your trading strategy. 

Employing the Right Indicators

This can be a tricky one. While you can explore a variety of indicators and even combination of indicators, which one to trust can be difficult. Putting the Pareto Principle to use, you may choose to use 20% of the indicators that have led to 80% of your profits on the demo account.

Risk Distribution

While allocating funds to various asset classes, make sure that 80% of the risk is consolidated in 20% of trading positions. This means 80% of your positions remain low-risk. This can significantly lower the volatility in your portfolio and allow you to focus on a small section of trades to adjust in the case the market moves unfavourably. 

Timing Your Trade

Forex and crypto markets are active 24 hours, but that does not mean you have to keep trading nonstop. According to the 80/20 rule, just find that 20% of the time you can use to place 80% of your trades. This could be a time when the trading hours of major global exchanges overlap, or a time when you are free enough to make rational decisions. The Pareto Principle says you can place 80% of your trades within that 20% window.

This also applies to recognising when 80% of your gains happen. For instance, do you lock in more profits during ranging markets, pullbacks, or trending markets, whether you gain by shorting or going long. Choose your trade timings accordingly.

Exercising Caution

Planning to rely on the rule completely? Don’t. It is important to remember that the 80/20 rule is not written in stone. It is only a guiding principle. The ratio can change to 70/30 or even 60/40. What this encourages us to do is to set up our own rules. Certain market conditions may be more conducive to a higher ratio. 

You can use the rule to evaluate your trading decisions and identify patterns in your trading style that have helped you make profits in the past. Also, it’s best to try this on a demo account before applying to live trading. 

Revisiting your trading strategy frequently, adjusting the 80-20 split to your needs, and staying abreast of news updates and market movements remain crucial to trading smart. Use the principle to develop a more focused strategy, but do not lose sight of the bigger picture. 

To Sum Up

• The 80/20 rule is a way to optimise efficiency.
• The Pareto Principle indicates that 80% of a trader’s gains come from 20% of positions. 
• The rule can be applied in trading to develop a trading strategy, manage risk, choose assets and indicators.
• The 80/20 rule is not law. It is only a guiding principle. 
• Stay aware of market sentiment and news while working with your 80/20 strategy. 

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