Applying Pareto’s Principle to Trading
In this fourth module of the course (Wisdom), we will explore the hidden truths about the mind and the markets in order for you to make money by trading.
In reality, the best trader makes money not by being in the market, but by knowing the difference of when to be and when not to be in the markets.
We will begin by exploring the psychology of trading, and then in the next lesson we will take a more in-depth look into the markets.
The 80/20 Rule
I cannot discuss the mind without mentioning the 80/20 rule as it provides much clarity to many concepts about life and how we are mentally designed.
The Italian economist Vilfredo Pareto discovered through his work and research the Pareto Principle, more commonly known today as the “80/20” rule.
In his early work he recognized that 80% of the land in Italy was owned by 20% of the people. He also noted that approximately 80% of Italy’s wealth was owned by 20% of the population. Interestingly enough, he then realized that this was rather a common ratio in many concepts of life much like the Fibonacci numbers appear in nature.
I like to apply Pareto’s theory to trading. In this context, 80% of your profits will come from 20% of your trades. This is crucial to figuring out what is your own “80/20” in the markets. Although I agree that figuring this out this will take time, the personal insight you will acquire is critical to your success.
The Pareto principle is not an exact science, and 80/20 is an approximation and might well be 75/25 or 85/15. By using this theory, we can hypothesis that in 80% of the cases, the market is simply not worth trading. Apply the Pareto principle in the context of your own trading.
The most important question you need to answer is:
- Which setups work best for you?
- On which currency pairs?
- And on which time frames?
By knowing this information you will develop a mental habit to recognize your favorable setups and awareness. By executing these trades more often than your typical ‘losers’, your target hit ratio will most likely increase and consequently make you more profit. As mentioned several times, removing your losers from the equation is the surest way to profitability.
It is your responsibility to find out what are those 20% of trades that are your main winners. I highly recommend using a trading journal and entering every trade in your log-book. Recording your trades will promote trading discipline and will encourage you to discover your own many strengths and weaknesses.
Know thyself. By building on your strengths by developing your 80/20 mindset, you will eventually increase your confidence in the markets and place better trades.
The Power of the Trading Journal
The reasons for implementing a trading journal should be obvious: precise measurement of your accuracy, testing and recording your results from your trading strategies, developing your 80/20 rule, maintaining your focus on selective high probability trades from trading plans, and having references for future trades.
Set-up and excel sheet or, if you’re old school start a physical folio, and split it in the following columns;
What I definitely recommend you do is at the end of every week (Friday at market close) recap your trading week and analyze your trades. Take the time to see if you can figure out where you went wrong/right with your trades and enter it into your log book.
Ideally some of the statistics you want to record is your;
- total weekly pip stop loss (PIP SL),
- total pip target (PIP TG),
- theory R:R,
- total actual pip and R:R (ACT),
- total trades,
- win ratio,
- ruin category (red, green, yellow from lesson I) and
- percent account growth.
Expert traders know all the statistics to their game. They use it to study where they can improve their system and they fine-tune it every week.
Another great idea to implement is in-depth trading statistics from the start of your trading career. For instance this Forex broker allows you to export your trades into an Excel spreadsheet. Then you can manipulate the data the way you want in order to figure out any glitches in your trading system.
The graph below shows a DWFX student’s account progression (several months of data). The equity curve has a fairly nice upward trajectory; however, the trader needs to work on his drawdowns. Notice how the trend line is sloping higher and higher upwards? This is another good sign of the student gaining confidence in the markets.
If you want to be really sophisticated with your trade tracking, you can use www.myfxbook.com.
This website allows you to link our recommended broker to your trading analytics account and track your progress automatically without exporting data. You can virtually see every statistic about your trading with this free service.
On this site you can see your most profitable currency pairs, your most profitable days, etc. If you do decide to use this service, this should not takeaway the need of keeping your trading log; it is only to be used for weekly observations of your trades. Never send a machine to do a human’s work.
You need to develop the proper mindset and discipline to become a successful trader. Myfxbook.com will not figure out your most profitable setup or timeframe. You really want to drill down the facts and determine your pot of gold. I have included a statistical database with this lesson, where you will have to enter your trades manually.
You will then be able to use the filters to see your own advanced statistics regarding your trading. Here is an example of the 80/20 Database
Ten Golden Rules of Trade
If you treat trading as a hobby, you will have hobby results. You will never be able to make that jump from being a trader who is ‘asleep’ to an awakened trader.
Serious traders create a strict plan and stick to it. All trades should abide by proper risk and money management principles to ensure long-term survival.
Your number one goal should be capital preservation.
Enter your trades in a trading journal. Discover your weaknesses and your strengths. Capitalize on your favourable setups. Figure out your 80/20 trades. Master a few trading strategies and become an expert at them.
Wait for printed price action signals before entering into the market and placing trades. Only when the price has been printed does it become fact.
Use several confirmations to support your trade: pin bars (t’s), inside bars (u’s), victory bars (v’s), engulfing bars (w’s) and false breaks (x’s), with confirmations or price action signals at value areas and other timeframes.
Identify the impulsive and corrective trends on the longer time-frames and trade with those trends unless if you notice a proper price action reversal setup. You don’t need to fight the Agents.
It pays to be a contrarian in the market. Wait for pullbacks to enter and never chase the market. If you missed out on a particular trade, wait for the next one. Don’t be a sucker and risk more money than what you are supposed to.
Identify the supports and resistance levels on the daily and weekly charts, and look for setups in these areas. Try to see if you notice an Agent holding a particular level. This will greatly increase your probabilities of a winning trade.
Watch out for victory and inside bars that have been over-extended. You will be risking too much money if the trend reverses.
Place your targets on the path of least resistance: 20ema, supports and resistance, or Fibonacci projections. You want your trades to hit your targets effortlessly.
You must learn where to pull out of the market as much as when to enter if you want to be an effective and profitable trader.
Wealth is not created nor destroyed, only transferred to the best trader in the room.
Signals You Should Avoid
False signals sometimes provide traders with misleading information about the market and as a result traders place bad trades. Although each setup discussed in this course will mention some potential traps, here are some other general signals that you should consider avoiding when placing a trade:
- Holiday bars;
- Sunday bars;
- Charts From Non New York Close Server time (non GMT)
Beware of Holiday Bars
Holiday bars usually form on light volume and a typical lack of commitment onto either side of the trade will lead to indecision in the markets. Holiday bars may create misleading price action signals and more famously, inside bars.
However, note that depending on where you live, you may have to consider other countries’ holidays. As a guideline I try to avoid having any trades open (or making any trading for that matter) on the following holidays: Christmas Eve, Christmas Day, New Year’s Eve, New Year’s Day, Easter, Fourth of July, and American Thanksgiving. Since there is usually low volume on these days, the market can be much more prone to attack by the agents, thus making it much easier to take prices up or down without much warning.
There are No Sunday Bars
Depending on your broker, you might have five or six candles a week. As a result, this may cause conflicting information or misleading signals from broker to broker. There are, technically speaking, no Sunday bars, since trading is ongoing from Monday to Friday in each country that is trading.
Therefore, as with the holiday bars above, it is wise to also avoid Sunday bar signals (depending on the broker).
Here is an example of a broker with six candles and a non-New York close chart. The circled candles on the chart represent Sunday bars. At the end, these Sunday candles usually print low volatility candles and are often inside bars that should not be traded. On the next page we will see a different broker using New York Close charts.
Charts From Non New York Close Server time
In the next chart we will examine another broker who also uses six candles; however, this broker’s server time is in sync with the New York Close (GMT +3).
This chart was taken at the same time as the one above. The difference is that you can see that this one printed a pin bar while the one above did not. One could have easily missed out on a good trade setup in the first one.
These charts are the ones that the Agents see and use every day. If you are looking at what they are seeing, it makes it much less difficult to spot trade opportunities.