You may have heard of the Pareto rule, which is applied to many aspects of financial trading as well as other purposes. The basic idea is that 80% of outcomes are the result of 20% of the causes. Therefore, small changes can make a big difference to the end result of a process. This theory has been adopted by forex traders to improve their strategy.
Here’s a look in some more detail at the Pareto Principle, and how you can use it to strengthen your forex trading performance.
Where does the Pareto Principle come from?
The idea is based on the observations of the Italian sociologist and economist Vilfredo Pareto (1848- 1923). He noted during the course of his studies that 80% of the land in Italy belonged to about 20% of the population. The story goes that this observation arose from noticing that 20% of the pea pods in his garden yielded 80% of the peas.
This led to the development of a power law distribution based around the 80/20 rule that has been applied to many other fields, particularly in the world of business and economics. In the 1940s, a management consultant named Dr. Joseph Juran applied the theory to quality control in factories.
He found that it held true for the proportion of defective products in relation to faults in the production process. In other words, 80% of the issues were caused by 20% of the flaws in the production method. Therefore, efforts to improve could be focused on one targeted area, which resulted in a great improvement in quality.
However, it has been applied to areas as diverse as engineering, quality control, and healthcare. Another area the principle is commonly applied is occupational health and safety, which assumes that 20% of hazards are responsible for 80% of accidents and injuries. This allows safety experts to target their efforts in the areas where they will have maximum effect.
In essence, the Pareto principle can reduce the time and effort spent trying to improve the many processes that matter only a little or not at all, and allow the work to be focussed on a much smaller area that will yield much greater benefits. It’s all about making the most efficient use of time, creativity, and resources.
Investors often work to the rule that 20% of the holdings in a portfolio are responsible for 80% of the growth, and thus focus their attention on the most lucrative stocks and shares.
How can the Pareto Rule be applied to forex?
There is no one single way that the Pareto Rule is applied to forex trading, but the general concept that 20% of your efforts will reap 80% of the rewards is a useful principle to bear in mind. Here’s a look at some of the different ways that you can integrate this approach to your trading.
Trade less, trade better
Less is more, as the saying goes, and many forex traders abide by this principle. One of the most effective ways this is applied to forex trading is to concentrate on making fewer trades that are very well planned, rather than a greater number of trades that have had less preparation.
Many new traders are keen to respond to every fluctuation in the market, rather than having the patience to wait until there is a worthwhile opportunity to make a good trade. More experienced traders develop the discipline not to trade when the market conditions are just not there.
Some traders might even tell you that 80% of the time, the market is not worth trading, but 20% it definitely is. Learn to identify that 20%, and use the other 80% to watch, wait, and keep your powder dry until the right moment. Learning when not to trade is just as important as knowing when to trade.
Analyse your trading journal
Take a look at your trading journal (you are keeping a trading journal, right?) and work out which are the best and worst performing trades. You may even notice that 20% of your trades generate 80% of your profit.
See if you can notice a pattern that repeats itself in your most unsuccessful trades, such as a certain time of day or currency pairing that just isn’t working for you. You may even find that your worst trades were those that you made impulsively without any proper planning and research, or were too influenced by your emotions such as greed and fear.
Next, look at your best results. Do they have any factors in common? Chances are, they are the trades where you were disciplined enough to follow through with your trading strategy and remained completely objective in your decision making process.
Whatever you find, look for the reasons behind the wins and losses in your track record, and refocus your energies on the techniques that are bringing you the best results.
80% of trading is about risk management
Forex trading is largely a process of taking managed risks. Even the most experienced of traders accept that only about 50% of their trades will be profitable. The reason why they continue to be successful is that they are able to manage their level of risk to minimise their losses.
The first step to risk management is to understand your risk tolerance; in other words, how much money are you comfortable with losing on each trade? Most forex traders are risk averse and will only risk between 1 and 3% of their account balance on each trade. Your approach will depend largely on your financial circ*mstances and personality.
Consider how much spare capital you have at your disposal, your level of trading knowledge and experience, and your temperament. Are you a natural worrier who would be kept awake at night by the thought of potential losses? Or are you someone who is comfortable with a level of uncertainty? How confident are you in your current trading abilities?
The other main risk management strategy is to use stop loss orders. No matter how confident you may be that you have identified a great trading opportunity, the markets are volatile and don’t always move in predictable ways.
A stop loss order automatically triggers an instruction to sell the currency pair at the market price once a predetermined price is achieved. This provides you with a safety net to mitigate against incurring substantial losses on any one trade, should the market suddenly turn against your favour.
It is important to note that when the stop loss is triggered, it becomes a market order, and is executed at the market price, which may be higher or lower than the stop loss price. It is possible to move your stop loss after your position is open, to protect a good profit margin or to move it out of the loss zone.
You may not want to set a stop loss on all your trades, but you can use the Pareto principle to identify your least successful 20% of trades and use stop loss orders for these.
Applying the 80-20 rule to your time management
One of the most effective ways to apply the pareto rule to your trades is by addressing your time management. If it holds true that 20% of our actions account for 80% of the outcomes, then it’s worth examining exactly how you spend your time when trading.
You may be familiar with the adage that work expands to fill the time available. This is known as Parkinson’s Law, because it was first observed by Cyril Northcote Parkinson in a 1955 essay for The Economist. In essence, it’s the idea that a simple five or ten minute task can take all day if we let it.
When we think that we have plenty of time at our disposal, it is easier to get sidetracked with small and often irrelevant details. We might also take more opportunities to procrastinate. Sometimes, this can be a useful learning experience, but mostly, it’s just an inefficient use of time.
To test how this theory might apply to you, limit your trading time by a few hours each week, or even each day if you devote yourself full time to trading. You might be surprised at how well you begin to focus on the most important aspects of your trading routine, and spend less time on the least productive tasks.
Note down how spending less time trading affects the outcome of your trades over the course of two weeks or a month. Did your success rate go up or down? You might be surprised to learn that you are getting better results, despite putting in fewer hours. It might be a cliche, but working smarter rather than working harder can really pay off.
Focus on your best performing currency pairs
Finally, this might seem obvious, but if you trade a lot of different currency pairs, it is likely that 20% of them are generating 80% of your profits. Unless you particularly enjoy the challenge of trading minors, it’s best to focus on the strongest currencies.
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