This is the reverse-engineering method to escape losing trades (Part 2)

Well, I’ve written so far as the first and the middle parts, and this time is the final third part. In the middle part last time, I introduced the “1% rule” and the “2% rule” as methods to avoid large losses. Simply implementing these rules can significantly reduce wasteful losses, but this time I’d like to dig one more layer and verify it.

— Knowing how to use the “risk-reward”

Have you ever heard of “risk-reward”? In short, risk-reward is the ratio of profit potential to loss potential and can be used in two ways.

The first use is to review your past performance; the formula is as follows.

“Average profit width (pips or amount) ÷ average loss width (pips or amount)”

For example, suppose you have traded several times and your past results are “average take profit 100,000 yen, average stop loss 200,000 yen.” In this case the risk-reward is “0.5.”

Or, if your average take profit is 200,000 yen and your average stop loss is 100,000 yen, the risk-reward is “2.0.” If take profit and stop loss are the same amount, it is “1.0,” and as a result, “below 1.0” means you are overall losing, while “above 1.0” means you are overall winning. If it becomes “2.0,” “3.0,” or “10.0,” profits will rise substantially.

And actually, win rate is not that important; what matters is the total amount of profit minus total loss (in pips).

Next is the second use. This is a method used when you are about to trade, and the formula is as follows.

“Target profit width (pips or amount) ÷ planned stop loss width (pips or amount)”

For example, if you are about to trade and a new entry (position) is, say, 100.00 yen, and your target profit price is 100.50 yen (+50 pips) with a stop-loss setting at 99.80 yen (−20 pips), then the calculation is “target profit width (+50 pips) ÷ planned stop loss width (−20 pips) = 2.5.” Personally, I think it’s best to trade with a risk-reward value of at least 1.5, preferably 2.0 or higher, so you won’t trade blindly.

— Six pattern verification results using risk-reward

Below, using the second method of risk-reward, I will introduce a verification with three win rates: capital 1,000,000 yen, win rates of “lose → win → lose → win” at 50%, “lose → lose → win → lose → lose → win” at 33%, and “lose → win → win → lose → win → win” at 66% (6 patterns).

First, in the case of win rate 50% for “lose→win→lose→win.”

• Risk-reward 1.5 (stop loss 1.0% of assets, take profit 1.5% of assets) with win rate 50%

Trade 1: 990,000 yen, Trade 2: 1,004,802 yen, Trade 3: 994,802 yen,

Trade 4: 1,009,724 yen, Trade 5: 999,626 yen, Trade 6: 1,014,621 yen,

Trade 7: 1,029,840 yen, Trade 8: 1,019,542 yen, Trade 9: 1,034,835 yen,

Trade 10: 1,024,486 yen

In this case, with a risk-reward of 1.5, even with a 50% win rate, you get more than 2.4% profit relative to your principal.

• Risk-reward 2.0 (stop loss 1.0% of assets, take profit 2.0% of assets) with win rate 50%

Trade 1: 990,000 yen, Trade 2: 1,009,800 yen, Trade 3: 999,702 yen,

Trade 4: 1,019,696 yen, Trade 5: 1,009,499 yen, Trade 6: 1,029,689 yen,

Trade 7: 1,019,392 yen, Trade 8: 1,039,780 yen, Trade 9: 1,029,382 yen,

Trade 10: 1,049,970 yen

In this case, simply increasing the risk-reward to 2.0 yields almost 5% profit relative to the principal. If you can achieve a 50% win rate, this is enough profit (note that this is not annualized; it is the result of 10 trades).

Next, let’s continue with win rate 33% for “lose→lose→win→lose→lose→win” using risk-reward 1.5 and 2.0.

• Risk-reward 1.5 (stop loss 1.0%, take profit 1.5%) with win rate 33%

Trade 1: 990,000 yen, Trade 2: 980,100 yen, Trade 3: 994,802 yen,

Trade 4: 984,853 yen, Trade 5: 975,005 yen, Trade 6: 989,630 yen,

Trade 7: 979,734 yen, Trade 8: 969,936 yen, Trade 9: 984,485 yen,

Trade 10: 974,641 yen

• Risk-reward 2.0 (stop loss 1.0%, take profit 2.0%) with win rate 33%

Trade 1: 990,000 yen, Trade 2: 980,100 yen, Trade 3: 999,702 yen,

Trade 4: 989,705 yen, Trade 5: 979,808 yen, Trade 6: 999,404 yen,

Trade 7: 989,410 yen, Trade 8: 979,516 yen, Trade 9: 999,106 yen,

Trade 10: 989,115 yen

We looked at risk-reward 1.5 and 2.0 in succession, and the results show that with 1.5 it is less than 2.6% of assets, and with 2.0 less than 1.1%. Even if you win only one out of every three trades, this method hardly reduces your assets. If you can ride a trend somewhere and gain a large profit, you can make a substantial positive result.

Now, finally, result for “lose→win→win→lose→win→win” with win rate 66% using risk-reward 1.5 and 2.0.

• Risk-reward 1.5 (stop loss 1.0%, take profit 1.5%) with win rate 66%

Trade 1: 990,000 yen, Trade 2: 1,004,850 yen, Trade 3: 1,019,923 yen,

Trade 4: 1,009,724 yen, Trade 5: 1,024,869 yen, Trade 6: 1,040,242 yen,

Trade 7: 1,029,840 yen, Trade 8: 1,045,288 yen, Trade 9: 1,060,967 yen,

Trade 10: 1,050,357 yen

• Risk-reward 2.0 (stop loss 1.0%, take profit 2.0%) with win rate 66%

Trade 1: 990,000 yen, Trade 2: 1,009,800 yen, Trade 3: 1,029,996 yen,

Trade 4: 1,019,696 yen, Trade 5: 1,040,090 yen, Trade 6: 1,060,892 yen,

Trade 7: 1,050,283 yen, Trade 8: 1,071,288 yen, Trade 9: 1,092,714 yen,

Trade 10: 1,081,787 yen

Risk-reward 1.5 yields over 5% profit on assets, and 2.0 yields over 8.1% profit on assets. Of course, this is not annualized; it is the result of 10 trades.

— Trade in a way that preserves capital more than chasing profits

Having looked at the six patterns, it becomes clear that it is better to trade in a way that preserves capital more than aiming for profit. In other words, many people trade with the mindset of “profit first,” and end up being stopped out, ending up negative overall.

Of course, not every trade will follow the above pattern. However, you can compensate for a low win rate by increasing the risk-reward, or vice versa; increasing both can accelerate growth of capital.

— Trade with grounded rationale and manage risk carefully

Finally, FX is an investment, not gambling, which is obvious. Yet many people engage in gambling-like trading, and as a result, lose capital, which leads to the unfortunate stereotype that “FX is high risk, high return and dangerous.” To reiterate, if you conduct grounded trading (with reasons explainable for why you enter each trade) and manage risk properly, you will not drastically reduce your capital. Moreover, as long as you do not significantly reduce your capital, there are plenty of opportunities to end up with a net gain. I hope that, like my students, more people will end up increasing their capital simply by preserving it.

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