We all know Pareto principle or the 80/20 rule and how powerful it can be for everything from time management to language learning.
I you have never heard of it before, then it basically says that 80% of your results will come from 20% of your efforts.
Approximately.
But does it work in trading? You bet it does!
In this post, I'll show you how this simple tweak can help you improve what you are already doing and give you a game plan to figure out if it is the right strategy for you or not. I will also show you my own results and how to implement this strategy, when it seems like you can't.
Ready? Here we go…
How the 80/20 Can be Used in Trading
OK, so the first thing we need to do is define where we will be using the 80/20 rule. Should we cut our screen time to only 20% of our current total? Should we only trade 20% of the available currency pairs?
Perhaps.
But what I'm talking about is splitting up our trade entry into two parts, with two different profit targets. The first profit target will be 80% of our total position, while the second part will be 20% of our total position.
Don't think that's possible?
Watch this…
A 80/20 Trading Example
This example is an Outside (or Engulfing) Bar setup on the $GBPAUD. Here is where the bar printed nicely on a support level. If you want to follow along at home, this the H4 chart on April 20, 2016.
Don't you wish that they were all that sweet? 🙂 I'm only showing you this ideal entry because it illustrates a good point. In reality, not all trades will work out this well.
When you enter the trade, you have several options. Here are some of the common ones:
- 1 position, 1 profit target
- 2 positions (50/50), 2 profit targets
- 2 positions (50/50), 1 profit target, 1 trailing stop
- 2 positions (80/20), 1 profit target, 1 trailing stop
So which one works best?
Obviously, there are many other variations, but those are the ones that people commonly use. Here's how they would have performed, risking 2% per trade, on a $1,000 account.
To make the calculations easy, let's say that we are using nano lots, so we can get the exact risk that we need. Also, 1 nano lot will be worth $0.001 and the spread/swap are negligible and there is no slippage.
In real trading, you can use nano lots to get this kind of risk customization, but the pip values will differ by pair and time of day. The spread/swap/slippage will factor into your profit and loss, but if you are using reasonable leverage, it won't be much, if you are trading during active hours.
Scenario #1: 1 Position, 1 Profit Target
This is the most basic entry and one that you have probably used before. In this example, using a 1R (or 1X the risk) profit target would have resulted in a 2% gain, or $20.
The stop loss was at 143 pips and the take profit was at 143 pips. So you would have used 140 nano lots. The calculation is as follows:
$20 (total risk) = 143 pips (risk) X 140 nano lots X $0.001 (/nano lot/pip)
Here's the entry (blue), stop (red) and take profit (green) lines.
Cool. But look at all that sweet profit you missed out on!
The upside of having a 1R profit target is that you will win often. Some trading methods have as much as an 80%-90% win rate on a 1R profit target. The downside is that your account balance can go up and down a lot because you don't take advantage of the big runs, so the losses can have a bigger effect on your account.
What happens if the 10%-20% of your losses come all at once? That can hurt and really mess with your head.
So a good balance of a good winning percentage and the occasional multi-R trade is ideal.
…which brings us to the next entry technique.
Scenario #2: 2 Positions (50/50), 2 Profit Targets
Now, if we had two profit targets, risking 1% on each (or 70 nano lots), that might help us catch more profit. In this case, it would have worked, and we would have made the following:
- Position #1: 143 pips X 70 nano lots X $0.001/nano lot/pip = $10
- Position #2: 246 pips X 70 nano lots X $0.001/nano lot/pip = $17.22
- Grand total: $27.22 or a 2.72% gain
So when we break it down, we only make an extra 0.72% over the 1 position entry strategy, in an ideal situation. Not bad, but let's also consider the more likely scenario, where the second position gets stopped out at breakeven.
Remember, when you go for 2R, you lower your probability for success by a lot. Sometimes it can drop to 30% or less, depending on the system.
- Position #1 (hits profit target): 143 pips X 70 nano lots X $0.001/nano lot/pip = $10
- Position #2 (move stop to breakeven when first target is hit, then gets stopped out): $0
- Grand total: $10 or a 1% gain
So your net reward/risk ratio is actually 0.5R. This is not completely terrible, but you are fighting an uphill battle. Your win rate (especially on the second position) will have to be high to overcome a less than 1R outcome on some trades.
Side note: I was doing this for years, wondering why I couldn't get ahead. This wasn't the only reason obviously, but it was one of the big ones.
We can do better…
Scenario #3: 2 positions (50/50), 1 profit target, 1 trailing stop
Now here's where things start to get interesting. What if we could lock in more than 2R when price really starts to rip?
…like in this GBPAUD example. So, in this scenario, we will move the stop to breakeven when price hits the first profit target. Then we will trail the stop by 1R.
Here's how the stop loss on the second position will look:
- Entry: -1R
- Price hits first profit target: move stop to breakeven
- Price hits 2R: move stop to +1R
- Price hits 3R: move stop to +2R
- And so on…
I've marked off the 1R intervals on the chart, so it looks like this.
It was really close, but you might not have moved your stop when price hit 6R. But let's just say you did.
In that case, the second position would have captured 5R. So in this scenario, we get the following results:
- Position #1: 143 pips X 70 nano lots X $0.001/nano lot/pip = $10
- Position #2: 715 pips X 70 nano lots X $0.001/nano lot/pip = $50
- Grand total: $60 or a 6% gain
Now we're talking! A 3X of the initial risk of 2%.
OK, before we go out and buy a Ferrari, let's take a look at the more probable scenario again:
- Position #1 (hits profit target): 143 pips X 70 nano lots X $0.001/nano lot/pip = $10
- Position #2 (move stop to breakeven when first target is hit, then gets stopped out): $0
- Grand total: $10 or a 1% gain
Still blows, right?!
It's much better because we have given ourselves the potential to capture big moves, but we are still fighting uphill if the second position never hits. We will still have to have 3 winning trades for every loss (75% win rate or better), or have a net 3R win on each position, in order to be net profitable.
…and it will really depends on how many big runs you have a year.
Not impossible, but we can probably do better.
Here's where 80/20 comes in…
Scenario #4: 2 positions (80/20), 1 profit target, 1 trailing stop
This is where we find balance.
In this scenario, let's do the same thing as in scenario #3, but tweak the entry parameters, so you put 80% of your risk into the first position and 20% in the second.
This is what the calculation looks like:
- Position 1: 140 nano lots X 0.8 = 112 nano lots
- Position 2: 140 nano lots X 0.2 = 28 nano lots
So the results in the ideal 5R scenario above are:
- Position #1: 143 pips X 112 nano lots X $0.001/nano lot/pip = $16
- Position #2: 715 pips X 28 nano lots X $0.001/nano lot/pip = $20
- Grand total: $36 or a 3.6% gain
Which is less than in scenario #3.
Buuuut….you make more when only the first profit target is hit:
- Position #1: 143 pips X 112 nano lots X $0.001/nano lot/pip = $16
- Position #2: 0 pips X 28 nano lots X $0.001/nano lot/pip = $0
- Grand total: $16 or a 1.6% gain
Remember, we aren't looking at just the total potential return per trade here, we are also looking at the probability of a positive return. To get an idea of how this works, let's say that you apply this advantage over 1,000 trades and you have an 80% chance of hitting the 1R profit target.
- Using Scenario #4:
- You will have 800 winning trades (1,000 X 0.8) and 200 losing trades.
- If you multiply that by 1.6% per trade, you will end up with a 1,280% gain, not including compounding.
- Then you will have 200 losing trades, multiplied by 2% risk, or a 400% loss .
- This gives you a net gain of 880%, not including compounding.
- Using Scenario #3:
- You will also have 800 winning trades and 200 losing trades.
- But at only 1% per trade, you will have a 800% gain, not including compounding.
- You will still have the same 400% loss.
- The net gain is 400%, not including compounding.
Again, these are very simplified numbers, but they illustrate the point that a tiny tweak in the entry can result in a huge gain in your final results.
Same system, same risk, different position sizing.
Think about how much more money that is over your trading career!
But, this isn't a magic bullet.
Here's what else you need to know…
When to Use the 80/20 Rule (The Catch)
Before you rush out and use this, consider this…
I'm not saying that everyone should do this. Like anything else in trading, this only makes sense in the context of certain trading styles.
Situations Where This Could Help You
- You have a high winning percentage on your first profit target
- You trade a swing trading or position trading method
- You have multiple profit targets
- You have access to trading nano lots
- Your current second or third profit target is fixed and is not taking advantage of big runs
Situations to Avoid
- Your first profit target has a lot probability of success
- You are a daytrader or scalper. Management of two positions might be a bitch.
- You don't have a tested method with positive expectancy
- You can't trade nano lots
Conclusion
In the end, the entry method you use is totally up to you. It will have to fit with your personality and there is no way that I can tell you what is right or wrong for you.
It is vital that you backtest this for yourself and see what works best for you.
But as you can see, using the 80/20 entry can improve your return on a trading method that already works. In our example, it actually doubled the return.
What kind of entry do you currently use? Leave a comment below…
