What Is the Pareto Principle in Trading?

In trading, rules that could maximise efficiency are highly sought after. One such principle is the 80-20 rule, also known as the Pareto principle. This concept asserts that 80% of outcomes often stem from 20% of causes. In software development, 20% of the bugs cause 80% of the problems. In customer service, 20% of the customers tend to account for 80% of the complaints, etc.

The Pareto principle has profound implications for trading strategies: by focusing on the most impactful factors, traders can potentially enhance their performance. This FXOpen article explains the 80-20 rule, exploring its origins, applications, and examples that illustrate its benefits.

Understanding the 80/20 Rule in Trading

The 80/20 method, or Pareto Principle, is a powerful concept that has found applications in various domains. It suggests that a small percentage of causes is responsible for a large percentage of effects. In trading, this means that approximately 80% of returns are expected to come from 20% of trades or trading strategies. Conversely, the remaining 80% of trades may only generate 20% of total returns.

Historical Background of the Pareto Principle

The Pareto Principle is named after Italian economist Vilfredo Pareto, who first observed this phenomenon in 1896. The principle's origins can be traced back to his observation and work in the early 20th century. Pareto found out that 80% of the land in Italy was owned by 20% of the population. This observation led to the broader conclusion that this 80-20 distribution applies to various aspects of life. Over time, the Pareto principle has been adapted and used in a wide range of fields, including economics, business management, and, notably, trading.

Examples of the Pareto Rule

Here are some illustrative examples of the use of the Pareto principle from different fields.

Business: In many companies, 20% of the products or services account for 80% of the company’s income. It is also often observed that 80% of the revenue comes from 20% of large corporate clients, while most customers don’t buy that much, for example, luxury cars from a manufacturer. Alternatively, consider a sales department where 20% of the salespeople generate 80% of the revenue for the company. The 80/20 rule in business works quite often.

Software development: Typically, 20% of bugs cause 80% of software problems. This insight helps development teams prioritise debugging efforts on the critical few bugs that have the most impact on the software’s performance and UX. Or it could be that 20% of the code accounts for 80% of the app’s functionality.

Wealth distribution: Vilfredo Pareto originally observed that 80% of Italy’s wealth was owned by 20% of the population, a principle that holds true in many economies today. This observation has implications for economic policies and wealth management strategies, where policymakers might focus on redistributive measures to address economic inequality.

Explanation of the 80-20 Trading Strategy

The unequal distribution of inputs and outputs is a fundamental concept underlying the 80-20 rule. A small subset of trades or trading instruments are likely to generate the bulk of one’s returns, while the majority of the trades might contribute relatively little or even result in losses. Additionally, a trader may find that a small subset of their skills or habits, such as risk management or emotional discipline, are responsible for the majority of their effectiveness, while other factors play a less significant role.

The rule can be a valuable tool for identifying and capitalising on the most trading opportunities while minimising efforts on less fruitful endeavours. To leverage this principle, traders focus their efforts on the most revenue-generating areas, as this can help optimise their strategies for potentially better outcomes. Focusing on these high-impact trades involves analysing past trades and looking for patterns to pinpoint the most promising opportunities and allocate resources accordingly.

Application of the 80/20 Rule in Trading

Let’s see how the 80/20 principle manifests in trading.

The first step is to identify high-impact trades. If a small percentage of trades contribute to the majority of returns, focusing on finding and replicating these high-impact trades can possibly increase the overall return on investment. Certain market conditions, such as high volatility, may lead to more effective trades, so one can follow the news or economic announcements related to them to stay informed.

The second step is to optimise the trading strategy. A trader might discover that a few technical indicators, such as moving averages or the Relative Strength Index, are responsible for the majority of their effective trades. Analysis may also reveal that the most effective trades occur during a specific time. For instance, some stock traders find that the first hour after the market opens or the last hour before it closes yields the most desirable results. If one prioritises some indicators in their analysis and focuses on peak trading times, it might require less effort to trade, and simplify the decision-making process, but still have optimal outcomes.

The third step is to allocate resources. Applying the 80/20 portfolio rule can help traders allocate their initial capital more effectively. Putting more in trades or assets that have historically been more effective may help maximise returns. For instance, if 20% of trades in particular trading instruments generate 80% of the returns, traders may allocate more capital to these high-performing assets.

The last step is to manage risk. Just as returns tend to be concentrated, so too can risks. Identifying the 20% of factors that contribute to 80% of the risk can help traders implement robust risk management strategies. This might include setting tighter stop-loss orders on trades that historically have higher volatility, avoiding certain market conditions, or adjusting position sizes to minimise risk exposure.

An Example of the 80/20 Rule in Trading

Consider a trader who reviews their trading history over the past few months and discovers that trades based on economic events accounted for 20% of their total trades but generated 80% of their gains. This pattern indicates that focusing on trading around economic announcements can be particularly effective for this trader.

This is just one of the Pareto principle examples in trading, and in your case, the situation and influencing factors may be different. To understand how the principle will work for you, you can open an FXOpen account, where you can trade over 600 financial instruments.

Practical Examples and Case Studies

Here are two more real-life trading scenarios.

A day stock trader might notice that trades made during the first hour of market opening, known as the opening bell, yield considerably higher returns than trades made at other times. Upon further analysis, the trader finds that this period accounts for 20% of their trading time but results in 80% of their daily earnings. With the help of concentrating their efforts during this time window and perhaps scaling back on trades made during other time periods, the trader may fine-tune their strategy.

The alternative case is when a trend-following trader noticed that 20% of their trades, specifically those that aligned with strong market trends, accounted for 80% of their returns. So, the 80/20 rule works for them, too. They adjusted their course of action to focus primarily on capitalising on these high-probability trend-following opportunities.

Challenges and Limitations of the 80/20 Principle

While the 80-20 rule can be a powerful tool for stock, cryptocurrency*, or forex traders, it is essential to recognise potential challenges in its application.

Accurately identifying the vital 20% can be difficult to do, especially in dynamic market conditions. Traders may need to continuously reevaluate and adjust their focus as market trends evolve.
The 80-20 rule is a generalisation, and the actual distribution of inputs and outputs may vary from the suggested ratio. It is a theory, not a strict practical rule.
Analysis of historical data may be distorted by survivorship bias, where only effective trades are considered, potentially leading to an overestimation of the 80-20 distribution.
Traders may face psychological challenges when strictly adhering to the 80-20 rule, such as the fear of missing out or the temptation to diversify their trading activities.

Traders should approach the 80-20 rule with a critical mindset, continuously monitoring and adjusting their strategies and maintaining a disciplined approach to risk management.

Summing Up

Identifying and focusing on the 20% of trading activities that contribute the most to returns and minimise risk factors can potentially minimise your efforts. This principle encourages traders to prioritise quality over quantity, leading to more streamlined and effective trading. However, it’s essential to recognise the limitations associated with the 80-20 rule and to approach it with a critical and adaptable mindset.

An application of the Pareto principle requires a combination of data-driven analysis, disciplined execution, and continuous refinement of strategies. If you want to practise trading it, consider the TickTrader platform, offering over 1200 trading tools.

FAQ

What Is the 80% Rule in Day Trading?

The 80% principle in day trading refers to the 80-20 Pareto rule, where a trader focuses on the few factors that contribute to most trading outcomes. The strategy aims to increase the frequency of effective trades by concentrating on the vital key factors that affect trading results.

What Is the 80/20 Trading Strategy?

The 80/20 trading strategy means that the minority of trades or market conditions can account for the majority of returns — approximately 80% of gains come from 20% of trades. This principle is about focusing on the most productive trading opportunities.

*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.