Zone and Potential Continuation Zone always exists together inseparable. If

Potential Reversal Zone exists, then Potential Continuation Zone must exists

too. As if a correct balance between Yin and Yang can achieve harmony and

great power, we were able to predict the market most accurately with the

Harmonic Pattern, which Potential Reversal Zone and Potential Continuation

Zone are balanced well. Therefore, you will need to have good understanding

on Potential Reversal Zone and Potential Continuation Zone for your

successful trading.

Figure 5-9: Figurative illustration of Harmonic Pattern with Potential

Reversal Zone and Potential Continuation Zone in the Yin and Yan principle.

6. Managing Reward/Risk Ratio with Real Time Market Data

We have shown that your chosen tolerance limit will control the size of the

Pattern Completion Interval for the final point D. For example, Pattern

Completion Interval 5% will give you narrower range than Pattern

Completion Interval 10%. Even though traders can choose different

tolerance limit for his trading style, in our guidance, we recommend using the

value between 5% and 15%. The reason behind our guidance is

obvious since it is likely to have visually flawed Harmonic Pattern with

tolerance limit greater than 15%.

Now it is time to discuss about entry price. Our entry price will have a great

impact on our Reward/Risk ratio in our Pattern Completion Interval Risk

Frame work. We will show you this with bullish Harmonic AB=CD pattern

in Figure 6-1 for an example. The lower limit of the pattern completion

interval can serve as our stop loss since below this level the pattern formation

will fail. In your Pattern Scanner, the Harmonic Pattern AB=CD will be

detected if the low of the candle is inside our Pattern Completion Interval

assuming the pattern scanner is operating in tick by tick or M1 or M5

interval. In Practical Trading Setup, we have discussed that we do not

recommend waiting for the confirmation candle. Instead, your entry decision

can be made while the price is staying inside the pattern completion interval.

Many junior traders trigger their trading as soon as they see the patterns since

they focus too much on completing the order execution with accurate number

entries. Entering the stop loss and take profit accurately in five decimal

places is important. However, it is more important to realize why you enter

the position now than later. Quite often, the immature trading decision will

end up poor trading results. Trading decision should be planned well since

some traders might allocate quite serious capital for one trading. At the same

time, it is also important to consider the speed of the decision making, as we

do not want to miss the right opportunity. If you are a quick thinker, it is

advantageous. Even if you are not quick thinker, it is not a problem since you

can train yourself to follow the established routine. Of course, in just few

trading sessions, your will not perfect your discipline. With some practice,

you will have a trained eyes and hands to do the job perfectly. We will

provide some useful guideline so you can make the accurate decision in less

time.

Figure 6-1: Stop loss and take profit expressed in Pattern Completion Interval

10% (i.e. Expected Reward/Risk=3).

In Figure 6-2, we show our Reward/Risk Calculation for different scenario

for bullish Harmonic Pattern. These Reward/Risk calculations are useful from

the first candle at the pattern detection to several candles afterwards. For the

case of bearish pattern, you have to turn around the Figure 6-2 to get the right

Reward/Risk calculation. In Figure 6-1, the open price gauger was placed

below many candle bars. The open price gauger is not an indicator itself. It is

a sort of ruler to help you think about your Reward/Risk ratio visually in your

chart. In Figure 6-2, we show the Expected Reward/Risk ratio equal to 3. We

use the term “Expected” in front of “Reward/Risk Ratio” since this is the

corresponding Reward/Risk ratio for the median open price. Statistically

speaking, the term “Expected” normally describe the average or mean values

of something.

The median open price was named since it is located in the middle of open

price gauger. This is not necessarily the most frequently occurring entry price

for traders. Your open price does not have to be set at the median open price.

If your entry price is set at the median open price, then your entry will get

you Reward/Risk ratio = 3 for your trading. At the same time, the median

open price is the upper tolerance limit for bullish Harmonic Pattern. The final

open price is located at the top of open price gauger. At the final open price,

you can just merely achieve the Reward/Risk ratio equal to 1. In any case, we

do not recommend having late entry above this final open price unless you

have identified highly probable stop loss below your final open price level

but above lower tolerance limit.

The half of the median open price is at the ideal pattern completion level for

final point D. At the half of the median open price, you can achieve

Reward/Risk equal to 7. Likewise, at the quarter of the median open price

you can achieve Reward/Risk = 15. Of course, this Reward/Risk calculation

are not considering the commission and slippage at your order execution.

Considering your commission and slippage, the Reward/Risk will be little

less than calculated values. Even after factoring out the commission and

slippage from our calculation, the Reward/Risk ratio at half and quarter of the

median open price will be quite something for traders. With below four

calculation tables, we will show the impact of your entry price on the

Reward/Risk ratio in details at the quarter, half, median open price and final

open price. In our calculation, we do not consider commission and negative

slippage for simplicity.

Below calculations reveal your profitability for the case of Reward/Risk = 15

at the quarter of the median open price.

1 wins out of 10: 1 x 15 x 1% - 9 x 1% = 6%,

2 wins out of 10: 2 x 15 x 1% - 8 x 1% = 22%,

3 wins out of 10: 3 x 15 x 1% - 7 x 1% = 38%,

4 wins out of 10: 4 x 15 x 1% - 6 x 1% = 54%,

5 wins out of 10: 5 x 15 x 1% - 5 x 1% =70%.

Below calculations reveal your profitability for the case of Reward/Risk = 7

at the half of the media open price.

1 wins out of 10: 1 x 7 x 1% - 9 x 1% = -2%,

2 wins out of 10: 2 x 7 x 1% - 8 x 1% = 6%,

3 wins out of 10: 3 x 7 x 1% - 7 x 1% = 14%,

4 wins out of 10: 4 x 7 x 1% - 6 x 1% = 22%,

5 wins out of 10: 5 x 7 x 1% - 5 x 1% =30%.

Below calculations reveal your profitability for the case of Reward/Risk = 3

at the median open price.

1 wins out of 10: 1 x 3 x 1% - 9 x 1% = -6%,

2 wins out of 10: 2 x 3 x 1% - 8 x 1% = -2%,

3 wins out of 10: 3 x 3 x 1% - 7 x 1% = 2%,

4 wins out of 10: 4 x 3 x 1% - 6 x 1% = 6%,

5 wins out of 10: 5 x 3 x 1% - 5 x 1% =10%.

Below calculations reveal your profitability for the case of Reward/Risk = 1

at the final open price.

1 wins out of 10: 1 x 1 x 1% - 9 x 1% = -8%,

2 wins out of 10: 2 x 1 x 1% - 8 x 1% = -6%,

3 wins out of 10: 3 x 1 x 1% - 7 x 1% = -4%,

4 wins out of 10: 4 x 1 x 1% - 6 x 1% = -2%,

5 wins out of 10: 5 x 1 x 1% - 5 x 1% =0%.

With greater Reward/Risk ratio, you need to win less. For example, at the

quarter of the median open price, you only need to win once to start to make

money out of 10 trades. Just two wins out of 10 will increase your capital to

22%. At the Reward/Risk ratio = 1, with 50% success rate, your profitability

is zero.

Carefully inspecting the four tables, you can see that well planned and well

executed few trades can increase your account quickly. It is not even 50

trades to see some notable changes in your account. Therefore, there is a need

to get rid of haste in your trading definitely. This haste is the typical enemy

of junior traders and starters from my experience. For practical trading, we

recommend to make the entry below the median open price which will offer

you Reward/Risk ratio = 3. In addition, remember that the four calculation

tables above do not consider compounding rate into account. For longer term,

the compounding rate will add more profit in your account.

In theory, you can achieve the infinite Reward/Risk ratio with our Risk

formulation here without too much market momentum. In practice, this is

impossible since most of brokers will round up your order entry price to 5

decimal places for Forex market and 2 decimal places for Stock market. In

addition, commission and negative slippage will eat up some part of your

profits too. If you can often spot the turning point below the half of the

median open price, for the case of bullish Harmonic Pattern, then it will

favour your trading outcome definitely due to high Reward/Risk ratio.

Figure 6-2: Reward/Risk Calculation for different scenario for Bullish

Harmonic Pattern.

In general, we recommend using the Pattern Scanner operating on the tick-

by-tick, M1 or M5 frequency assuming you are trading on Hourly or daily

chart. It is even better if you have an automatic calculator showing the

Reward/Risk Ratio while the price is changing below the Final Open Price.

Make sure that your entry must offer you the sufficient Reward against your

Risk. Once the price moved beyond the Final Open Price, we have very little

justification for entry unless you can identify another highly probably stop

loss level near the Final Open Price.

Scanning the patterns on tick-by-tick, M1 or M5 frequency might be not

available to every traders. Many stock traders still analyse patterns over the

end of day data using the external pattern scanning software. Then they will

execute their orders from the different real time chart provided from the web-

based trading platform. In that case, traders can take note of Pattern

Completion Interval, median take profit and stop loss level from the external

Pattern Scanner. Since the Pattern Completion Interval is the fixed range for

the detected pattern, the median take profit and stop loss levels are invariable

either. Even though the actual pattern and ratios are not drawn in your chart

in details, the presence of these levels on your chart will help you to make the

same efficient trading decision.

Figure 6-3: Median Take Profit, Stop Loss and Pattern Completion Interval

drawn in the chart without showing actual pattern and ratios in details.

Practically speaking, many starters are curious if you have to trade

immediately after you see the pattern or you should wait. This question point

out why Pattern Completion Interval is powerful concept for your trading.

The answer is that you do not have to trade immediately after the harmonic

pattern detection although you can definitely. The truth is that not all the

patterns will immediately point out the turning point. Sometimes, it can take

several attempts before showing the definite turning point. While price is

staying inside PCI and below the median open price, you can use this time to

develop your decision. It is important to gather sufficient information and

make your trading decision. For this reason, we do not recommend for

starters and junior traders to use lower timeframe. In lower timeframe like

M1 or M5 or M15, your decision-making has to be much faster than higher

timeframe. In higher timeframe, you can typically make your entry decision

more comfortable with enough time.

Figure 6-4: Median Take Profit, Stop Loss and Pattern Completion Interval

drawn for Gartley pattern in EURUSD H1 timeframe.

7. Insignificant Turning Point, Local Turning Point and Global

Turning Point

If harmonic pattern could predict the potential turning point, we can choose

to materialize this opportunity or not. We covered that this prediction is

subject to probabilistic nature. Harmonic Pattern is not a bulletproof predictor

of the future. If you find someone mentioning 95% or 96% or even 90%

prediction accuracy whatsoever, you could just step away from those bullshit.

Most of time, its two things, that person does not know what he is talking

about or that person might want to cheat on you. Simply let us not involved

on that time wasting activities. We have already shown you how to calculate

your profits in previous chapter. There is certainly no need to talk about 95%

prediction accuracy in our trading.

Harmonic Pattern Trader needs to understand that our turning point

prediction can end up few distinctive scenarios. Our turning point prediction

can spot the global turning point as shown in Figure 7-1. This is the best

outcome you can achieve with harmonic pattern trading. Since we can ride

the big trend from the start to an end, we can materialize almost the entire

trend range for our profits. Considering our stop loss was just 10 to 20 pips,

for example, our Reward can be something like 500 or 1000 pips sometimes.

Reward/Risk ratio like 30 or 50 is a mega deal to traders. Of course, this is

very rare opportunity in real world trading. However, at least, it is not

difficult to hear that someone hit the turning point dead accurately and his

investment is running almost without any drawdown. To meet such a mega

opportunity, we need both luck and discipline for our trading. The good news

is that Harmonic Pattern can spot one of these opportunities because it is

turning point predictor. In general, many trend based trading strategies will

likely enter the market much later after the turning point happens.

Since the global turning point formation requires huge trading volumes to

push the price forwards, we are less likely to catch this movement in the

probabilistic sense. Instead, our turning point prediction can spot the local

turning point more often as shown in Figure 7-2. In that case, we will only

catch correction against the trend. In fact, more often, we will end up with

local turning point or we can be wrong with our prediction. If your trading

plan involves waiting for the global trend, statistically speaking, you are

likely to lose more often. Especially if your stop loss is tight, then you will

lose more. This is even true to many seasoned traders. Luckily, in trading, the

size of trend does not matter for our profit if we can manage our order in

proportion to our trading capital. For example, if your risk is set to 1% of

your trading balance and Reward/Risk ratio =5, then it does not matter

whether the market moves 200 pips (i.e. global turning point scenario) or 20

pips (i.e. local turning point scenario). As long as the market hits the take

profit, we will bank the same amount of profit into our accounts, which is 5%

of our trading capital in our example. With some help of fundamental

analysis and long term technical analysis, it is not impossible to predict on

the global turning point prediction. In addition, it is also possible to catch

both local and global turning point by opening multiple of positions for your

trading. For example, by sending one order with Reward/Risk ratio = 3 and

sending second order with Reward/Risk ratio = 12, you can increase your

potential to catch both local and global turning point.

Regardless of the turning point scenarios, the risk formulation with the

Pattern completion Interval can help traders to precisely form stop loss and

take profit levels within the confined price and time space in your chart. At

the same time, the price can move much quicker within the confined price

and time space. Some discipline must be accomplished to master the

Harmonic Pattern trading in practice. Harmonic pattern trading is not a

bulletproof technique. Practically, many times, you will observe that

harmonic pattern can predict the insignificant turning point. This means that

the reaction at final point D is not significantly large for us to take the profits

out. Sometimes, the final point D can be totally ignored by the market and

price can just pass through the final point D without making any turning

point. For this reason, you have to try to enter the market when there is higher

chance of success. In general, you should not rely on harmonic pattern alone

to make your trading decision. You have to make use of secondary

confirmation with other technical analysis. It is advantageous if you can read

the fundamentals of the market but it is not compulsory though. However, for

the healthy growth of your trading capital, the right risk management should

be in place without exception.

Figure 7-1: Harmonic Pattern predicting global turning point.

Figure 7-2: Harmonic Pattern predicting local turning point.

8. Market Order and Risk Management

Just like any trading strategy, we need a discipline to trade harmonic pattern.

In this chapter, we introduce practical order and risk management techniques

using the Pattern Completion Interval. With the Pattern Completion Interval,

the final point D of the harmonic pattern can be treated as a trading zone

instead of a single price level. The advantage of trading zone over a single

price level is countless because we can use many order management

techniques around the trading zone. Firstly, we will start with market order.

Market order is the fastest order type you can execute. With market order,

you will buy and sell at the current ask and bid price respectively. The

difference between ask and bid price is called spread. In our order and risk

management, we prefer to send market order while the price is within the

pattern completion interval. When the price is within the pattern completion

interval, it is easy to maintain the desired reward/risk. The market order

scheme is shown in Figure 8-1 for the case of buy signal. The convenient

place to measure the take profit and stop loss target is to start from median

open price, i.e. upper limit for the point D for the case of buy. It is convenient

to express the take profit and stop loss in the ratio against the height of

interval box. Take profit ratio 3 is equivalent to the three times the height of

the interval box. If your interval box size is 50 pips, then take profit ratio 3

means that your take profit target is 150 pips away from the median open

price. Likewise, stop loss ratio 1 means that your stop loss target is 50 pips

away from the median open price. Such take profit and stop loss

measurement get rid of any trouble of finding out the average market

movement from the trading instruments. For example, the 30 or 50 pips are

sensible stop loss size for EURUSD and several major forex symbols.

However, the 30 or 50 pips are not sensible stop loss size for many other

forex symbols, commodity and many stock prices. If you are sending the buy

market order while the ask price is within the Pattern Completion Interval,

the minimum Reward/Risk ratio you can achieve is simply:

For example, with take profit ratio 3 and stop loss ratio 1, the minimum

reward/risk ratio you can achieve is 3 with potential of more. If the ask price

stays below the median open price, your reward/risk ratio will be greater than

3 for buy order. Likewise, if your ask price stays below the half median open

price, your reward/risk ratio will be greater than 7 for buy order.

Furthermore, if the ask price stays below the quarter median open price, your

reward/risk ratio will be greater 15 for buy order.

Figure 8-1: Market Order Scheme for bullish harmonic pattern with two buy

orders with different take profit and stop loss size (left and right) where Tr1 =

Take Profit Ratio 1, Tr2 = Take Profit Ratio 2, Sr1 = Stop Loss Ratio 1 and

Sr2 = Stop Loss Ratio 2.

When you anticipate the higher chance of turning point with Harmonic

Pattern, then you can use this market order scheme in Figure 8-1. However,

sometimes, harmonic pattern can fail to predict the turning point. Sometimes,

market can ignore the harmonic pattern and the price can go down even

further below the final point D for bullish pattern. In such a case, it is

possible to think about reversing our buy order. Instead of sending buy order,

you can send sell order. As we have learnt in the Potential Reversal Zone

(PRZ) concept, the market may not turn at the final point D but we can still

have an explosive price moment around the final point D in the same

direction from point C to D. This can happen because the current trend is still

growing with momentum and the trend is not near the end yet. Figure 8-2

shows the reversed market order scheme for buy order. In the reversed

market order scheme, your median open price is reversed too. Lower limit of

Pattern Completion Interval can act as the median open price for your sell

order. This does not mean that you have to sell around the median open

price. As long as the bid price is above the Lower Limit of Pattern

Completion Interval, you can make sell order. As before, your take profit and

stop loss can be measured from the median open price. For example, consider

your take profit ratio and stop loss ratio are one and one respectively. If the

bid price stays above the median open price, you can achieve your

reward/risk ratio greater than 1. If the bid price stays above the half median

open price, you can achieve your reward/risk ratio greater than 3. If the bid

price stays above the quarter median open price, you can achieve your

reward/risk ratio greater than 7. Depending on the Expectation of how much

price can go down, you can formulate your take profit and stop loss

accordingly. Your take profit and stop loss ratio does not have to be one

always like above example. If you have an ability to think about the

achievable Reward/Risk ratio in the given scenario, it is not difficult to setup

the right take profit and stop loss ratios.

Figure 8-2: Reversed Market Order Scheme for bullish harmonic pattern with

two reversed buy orders (=sell orders) with different take profit and stop loss

size (left and right) where Tr1 = Take Profit Ratio 1, Tr2 = Take Profit Ratio

2, Sr1 = Stop Loss Ratio 1 and Sr2 = Stop Loss Ratio 2.

Another variation of market order scheme for harmonic pattern trading is

using the Fibonacci retracement ratio between point C and D for your take

profit target. In this setup, you will measure take profit target from the actual

point D from your chart. Your take profit target is no longer related to median

open price. Except that, everything else is the same as previous market order

scheme. For example, you will measure your stop loss from the median open

price as before. In this alternative market order scheme, you are no longer

able to calculate your minimum Reward/Risk ratio using the take profit and

stop loss ratios. To calculate your minimum Reward/Risk ratio you have to

measure the pip distance of your take profit and stop loss targets from median

open price. To calculate the actual Reward/Risk ratio you have to measure

the pip distance of your take profit target and stop loss target from the actual

open price at the order execution. You are not able to use half median open

price and quarter median open price to get some idea for your potential

reward/risk ratio for the given open price. This trading setup can take few

extra steps to calculate your Reward/Risk ratio. However, this is a valid

market order scheme for your harmonic pattern trading.

Figure 8-3: Market Order Scheme for bullish harmonic pattern with

Fibonacci retracement CD for two buy orders with different take profit and

stop loss size (left and right) where Tr1 = Take Profit Ratio 1, Tr2 = Take

Profit Ratio 2, Sr1 = Stop Loss Ratio 1 and Sr2 = Stop Loss Ratio 2.

9. Pending Order and Risk Management

When you trade with harmonic pattern, market order is not always necessary.

You can use limit and stop orders equally in place of the market order.

Especially Pattern Completion Interval provides you the sufficient

information to place these pending orders as soon as harmonic pattern is

detected. Consider few different turning point scenarios, which can happen in

real world trading. As long as the final point D is located inside the Pattern

Completion Interval, the pattern is valid. However, some cases, it is possible

to meet the turning point with much deeper angle as in the turning point

scenario 3 and 4 in Figure 9-1. Consider the turning point scenario 3 in

Figure 9-1 for further explanation. While the ask price is at P1 location, the

market buy order is not the best choice because the price can still go down

below the ideal D level. We will experience the drawdown with the market

order sent at the ask price at P1. To prevent the drawdown, we can use limit

pending order. For example, we can set the buy limit pending order at P3.

Once the buy limit order is sent to your broker, the buy limit order is not

going to be executed until the ask price is actually hit the price level at P3.

You can use buy limit order when you expect that current market price will

do down more but your overall analysis point out the high chance of turning

point in the harmonic pattern. Sometimes it is possible to use limit pending

order in the case of failed harmonic pattern as shown in the turning point

scenario 4 in Figure 9-1.

Figure 9-1: Several different turning point scenarios around Pattern

Completion Interval after bullish harmonic pattern formation.

How to apply the limit order is almost identical to setup the market order.

Take profit target and stop loss target are measured from the median open

price. Since we can’t use the ask price, we need to specify the open price to

complete our limit order. Open price can be simply measured from the

median open price too using the ratio of interval box size. Likewise, in case

of the insignificant turning point, we can set up the reversed limit order. For

reversed limit order, we will set sell limit order for bullish harmonic pattern.

Stop loss target, take profit target, and open price will be measured from the

lower limit of the Pattern Completion Interval. It is possible to setup the take

profit target using the height of CD instead of the Pattern Completion Interval

as shown in Figure 9-4.

Limit order can provide you many advantages for your trading. However, if

the price does not hit the specified open price, then limit order will not be

executed. For example, you have anticipated the turning point scenario 3 with

newly detected harmonic pattern and you have sent the buy limit order

instruction with the open price at P3. If the turning point scenario 2 was

happened instead of turning point scenario 3, then your order will not be

executed. The other important point to note is that limit order is that the

reverse limit order setup in Figure 9-3 provides the perfect symmetrical

hedging to the limit order setup in Figure 9-2. For example, when the market

price is in the middle of the Pattern Completion Interval box, you can setup

buy limit order and sell limit order together to form a symmetrical hedging

limit order. How to use the effect of hedging limit order is entirely up to your

purpose and the level of your trading knowledge. Finally, when you use limit

order, you have advantage of having greater Reward/Risk ratio in comparing

to the typical market order setup. It is possible that you could reduce the size

of take profit target to match the reward/risk ratio of the typical market order

setup as shown in Figure 8-1.

Figure 9-2: Limit Order Scheme for bullish harmonic pattern with two buy

limit orders with different take profit and stop loss size (left and right), where

Tr1 = Take Profit Ratio 1, Tr2 = Take Profit Ratio 2, Sr1 = Stop Loss Ratio

1, Sr2 = Stop Loss Ratio 2, Or1 = Open price Ratio 1 and Or2 = Open Price

Ratio 2.

Figure 9-3: Reversed Limit Order Scheme for bullish harmonic pattern with

two reversed buy limit (sell limit) orders with different take profit and stop

loss size (left and right), where Tr1 = Take Profit Ratio 1, Tr2 = Take Profit

Ratio 2, Sr1 = Stop Loss Ratio 1, Sr2 = Stop Loss Ratio 2, Or1 = Open price

Ratio 1 and Or2 = Open Price Ratio 2.

Figure 9-4: Limit Order Scheme for bullish harmonic pattern with two buy

limit orders with different take profit and stop loss size (left and right), where

Tr1 = Take Profit Ratio 1, Tr2 = Take Profit Ratio 2, Sr1 = Stop Loss Ratio

1, Sr2 = Stop Loss Ratio 2, Or1 = Open price Ratio 1 and Or2 = Open Price

Ratio 2.

As with limit pending order, we can use stop pending order too. The

difference is that buy stop order can be placed above current ask price only

whereas the buy limit order can be placed below current ask price only. For

the stop pending order to be executed, the market price must make a turning

point after it hits the Pattern Completion Interval. Since our open price for

stop order is typically located outside the Pattern Completion Interval box,

the concept of median open price is no longer available for stop order. For

this reason, both take profit target and stop loss target are measured from the

actual open price. We can still keep the take profit and stop loss ratio in terms

of the height of the interval box. The reward/risk ratio can be simply

calculated by dividing take profit ratio by stop loss ratio.

The open price can be measured from median open price. This gives us a

sense of the deviation of the open price from the median open price level. As

in the limit pending order, the stop order may be not executed if the open

price is deviated too much from the median open price. In addition, the open

price of stop order can stay inside the Pattern Completion Interval box too.

For example, current ask price must be lower than the open price of the buy

stop order. When the current ask price is below the ideal D level, you might

utilize the buy stop order instead of buy market order. In addition, expressing

take profit ratio in terms of the height of CD is not recommended for stop

order because the lifted open price outside the Pattern Completion Interval

can overlap with take profit price.

With stop order, it is possible to setup the reversed stop order too. Trader can

use this reversed stop order when we expect that the turning point at Point D

is insignificant. As in the limit order, stop order and reversed stop order can

provide you with perfect symmetrical hedging model too. When you apply

stop order and reversed stop order at the same time while the current market

price stays around the ideal D level, the trading setup is identical to the

typical straddle trading setup. The straddle trading setup is commonly used

by many trader when the market is expected to make highly volatile

movement in both up and down direction (Figure 31).

Figure 9-5: Stop Order Scheme for bullish harmonic pattern with two buy

stop orders with different take profit and stop loss size (left and right), where

Tr1 = Take Profit Ratio 1, Tr2 = Take Profit Ratio 2, Sr1 = Stop Loss Ratio

1, Sr2 = Stop Loss Ratio 2, Or1 = Open price Ratio 1 and Or2 = Open Price

Ratio 2.

Figure 9-6: Reversed Stop Order Scheme for bullish harmonic pattern with

two reversed buy orders (sell order) with different take profit and stop loss

size (left and right) where Tr1 = Take Profit Ratio 1, Tr2 = Take Profit Ratio

2, Sr1 = Stop Loss Ratio 1, Sr2 = Stop Loss Ratio 2, Or1 = Open price Ratio

1 and Or2 = Open Price Ratio 2.

Figure 31: Breakout illustration around Pattern Completion Interval for

bullish harmonic pattern.

10. Practical Trading Management

10.1 Various Risks in Trading and Investment

Trading and investment carry risk. The opportunities in trading and

investment without risk rarely exits except some arbitrage opportunities,

which will not be discussed in this book. In theory, you could develop several

classes of risks for trading and investment. For example, risk in trading and

investment can be classified as Macro and Micro risks depending on where

they are originated. Macro and Micro risks can be subdivided further into

smaller categories like the market risk, operational risk, liquidity risk, credit

risk, political risk, etc. Since this book is not the theoretical textbook, we only

describe some examples of Macro and Micro risks in Table 10-1 for your

trading. However, this list is definitely not the exhausted one.

Risk Factors Description Examples Exposure on Nature

Market Risk Trader/broker Marco

Political risk Macro

Interest rate risk Risk of changing the Microsoft Window is losing Trader: Yes Macro

fundamentals of the its market share due to the Broker: No

Operational Risk underlying security due to the wide popularity of android Micro

competitive market OS developed by Google.

environment.

Risk associated with the Large change in the currency Trader: Yes

possibility of unfavourable value and stock prices after Broker: Yes

government action or social the presidential election.

changes resulting in a loss of

the security value.

Risk that an investment’s If interest rate increase, bond Trader: Yes

value will change due to a prices fall. When interest Broker: Yes

change in the absolute level of rates fall, then bon price rise.

interest rate. In addition, interest rate

change cause huge spikes on

Forex market too.

Risk that originates from the You have executed your Trader: Yes

mistake of the operator or the order with wrong stop loss Broker: Yes

company during its trading and size or wrong contract size.

investment process.

Liquidity risk Risk that refers to the You want to sell your 10 Trader: Yes Micro

difficulty of converting the million shares of Google but Broker: Yes Micro

assets to cash at the fair value. your broker cannot find buyer

of your shares because of the

large volume.

Credit risk Risk or possibility that the Your broker gone bankrupt so Trader: Yes

operator or company can go your trading account is Broker: Yes

bankrupt. suspended from trading.

Table 10-1: Common risks for your trading and investment.

Trader and investor are exposed on both Marco risks and Micro risks every

day. Macro risks like the market risk, political risk and interest rate risk are

caused by the external factors outside your trading operation. Most of time,

these external factors are not controllable by us. In fact, some of the technical

and fundamental analysis might be used to protect traders from these Macro

risks. However, some of the risky event can not be warned at all even using

any technical or fundamental analysis. For example, trader can make some

educated guess on the possible depreciation or appreciation of the currency

by looking at some Macro-economic data and technical analysis. Likewise,

by studying the company balance sheets and by applying many technical

analyses, we can guess that if the company is increasing their market share

from its competitors. On the other hands, guessing when the government will

increase or decrease the corporation tax is impossible with any technical or

fundamental analysis. Macro risks can contribute to the predictable and non-

predictable parts of the market. In fact, many technical and fundamental

analyses are there for you to reduce the Macro risks for your trading.

Charting techniques and technical indicators can help you to identify the

short-term or long-term price movement up to some degree. Besides the

technical analysis, monitoring the important news can reduce the market risks

too. For example, trader need to watch out any news about the taxes or labour

laws, trade tariff change, environmental regulation or reformation in the

national economy because they can change the entire market dynamics.

Some Micro risks like operational risk and credit risk can be originated from

trader or from broker internally. In 2009, trader at UBS, the Swiss banking

giant, placed a $22 billion of Capcom bonds in mistake while trying to buy

just £220,000. In 2012, Knight Capital lost nearly $440 million in just 30

minutes because their trading software sent erroneous orders. These types of

fat finger mistakes are the typical operational risk in trading. Operational risk

can be made by anyone or by any algorithm. Sometimes, some trading

platforms have many protective systems to prevent some common

operational risk but not all of them can be prevented. You can still send

wrong contract size or wrong stop loss size to your broker anytime.

Especially the erroneous automated trading system can send the erroneous

orders at high speed. The penalty from the mistake is always 100% yours. If a

book was accidently dropped on your keyboard and hit the enter key sending

the market order with 10 million contracts to your forex broker, you will lose

a lot of money on commission even if you close the order immediately. You

can not blame other people for this accident. To prevent the operational risk,

trader needs to be highly cautious in their trading. It is better to avoid trading

when you are not set for the trading. If you are working in a team, it is

important to monitor each other to prevent such silly mistake. If you have to

build the automated trading algorithm, the operation of the algorithm must be

fully tested in the paper account first.

Credit risk is another Micro risk, on which both trader and broker are heavily

exposed. Simply speaking, credit risk is the chance of experiencing the

bankruptcy for the business organization. Any business organization can go

bankrupt. Trader, broker or any liquidity provider can face the bankruptcy.

The insolvency of the Alpari UK, currency broker, due to the Swiss franc

turmoil in 2015 was a good example of the credit risk exposed by the

currency brokers. From the trader’s point of view, trader can always lose their

entire capital or nearly entire capital from their trading. If the operational risk

can be considered as a mistake, credit risk often happens because traders are

not educated or not experienced. Except that your account blowing was

experimentally carried out on the small account for some educational

purpose, this experience can cause serious damage to your finance. For

traders, the credit risk is normally originated from the lack of understanding

on the market volatility and position sizing.

Consider the aggressive trading example in Table 10-2, where the credit risk

is amplified to blow your account. Your starting balance is 10,000 US dollar

and pip value for EURUSD is 10 dollar per pip in this example. In this

trading example, a trader used the aggressive trading volume for each trade.

Luckily, he got the two winning trades increasing his account to 30,000 US

dollar initially. Then his luck was run out losing all his account in next three

trades. Can you imagine how he would feel in his first two trades? Can you

imagine how he would feel after he lost all his account? In this trading

example, his obvious mistake is to use the excessively large trading volume.

This sort of mistake typically happens to starters who ignore to learn how the

pip value and contract size relate the market movement to the profit and loss

on his holding positions.

Order Symbol Entry Volume Take Profit Stop Trading Profit/Loss in Total

ID EURUSD Buy in Lots in pips Loss in Results Dollar per Profit/Loss in

1 EURUSD Buy 20 50 pips Win trade Dollar

2 EURUSD Buy 20 50 50 Win 10000 20000

3 EURUSD Buy 20 50 Loss

4 EURUSD Buy 20 50 50 Loss 10000 30000

5 20 50 Loss

50 -10000 20000

50 -10000 10000

50 -10000 0

Table 10-2: Aggressive trading example for trader A.

Now consider another trading example in Table 10-3. Starting balance and

pip value is identical to the first trading example. In this trading example, the

trader started with two lots. Unfortunately, the first two trading gone badly

and he lost 2000 US dollar. He is definitely new to the game of trading.

Therefore, he decided to chase the loss and increased his trading volume to

10 lots. Another bad trade comes and he lost another 5000 US dollar. Now

his broker does not allow him to open the trading volume greater than 2 lots

due to the margin requirement set for his account. Therefore, he cannot

continue the gambling anymore. He is financially and psychologically

exhausted only after four bad trades.

Order Symbol Entry Volume Take Stop Trading Profit/Loss in Total

ID EURUSD Buy in Lots Profit in Loss in Results Dollar per Profit/Loss in

1 EURUSD Buy 2 pips pips Loss trade Dollar

2 EURUSD Buy 2 50 50 Loss -1000 9000

3 EURUSD Buy 10 Loss

4 EURUSD Buy 2 50 50 Loss -1000 8000

5 1 Win

50 50 -5000 3000

50 50 -1000 2000

50 50 500 2500

Table 10-3: Aggressive trading example for trader B.

The first and second trading example can happen to starters when they are

trading on the leveraged products. In the first trading example, trader did not

know how the fluctuation in the market affects the profit and loss of his

holding position. Such information is summarized in the single quantity, the

pip value for the leveraged products like Forex and Future. For example, if

one pip value were 10 US dollar, then he would experience ± 10 US dollar in

his position per 1 lot trading volume per 1 pip movement in the market. If his

stop loss is 50 pips, then he could experience up to -50 US dollar loss per 1

lot trading volume. In addition, he could experience up to -500 US dollar loss

for 10 lot trading volume. In the second trading example, it was the

psychology triggered the aggressive trading volume later. If a trader is

continuously exposed on the psychological bias like this, simply he can not

win in the financial market.

10.2 Position Sizing Techniques

If you are trying to borrow money to buy the house or car from your bank,

you are the subject of the credit risk to the bank. This means that the bank

have to concern that you might not able to pay back the money. When you do

not pay back the money, it would change your credit rating from good to bad.

At the same time, the bank will make a loss. What the bank can do to limit

their credit risk when they lend money to you? Well, the first thing they can

do is limiting the amount of lending so you can definitely pay back the

interest and principal amount each month. For example, they can lend money

to you in a way that your interest and principal payment each month is not

exceeding 30% of your monthly income. Setting limit is the key to prevent

the credit risk. We can apply the same idea to our trading. We can set the

limit on our loss per each trade to maintain the healthy growth of our capital.

That way we can reduce the credit risk we are exposed on our trading. Such a

technique is called Position Sizing in trading. It is the first risk management

tool when you trade on the leveraged products. We list several different

position sizing techniques. They include:

Fixed position sizing, when stop loss size is not available

Fixed fractional position sizing, when stop loss size is known

And Position sizing using Kelly’s criterion.

In the Fixed position sizing, we simply use the fixed lot size per your trading

capital. For example, you might set to use 0.1 Lot per 10,000 US dollar

capital to trade on EURUSD symbol. You will revise your lot size when your

account reaches 15,000 or 20,000 US dollar later. With the Fixed position

size, it is not easy to give the definite trading volume sometimes because the

fixed position size can heavily depend on your trading strategy and the

market volatility. For example, if you are using trading strategy based on

averaging or grid or pairs trading strategies, then you might have some idea

of the appropriate trading volume from your backtesting or forwards testing

results. Then why we introduce the fixed position sizing? Because the fixed

position sizing is useful when the trading strategy does not use the stop loss

and it controls the risk by other means like Drawdown or Sharpe ratio, etc. In

such a case, you can not use the fixed fractional position sizing.

Most of time, we recommend to use the fixed fractional position sizing if the

stop loss size is always known for your trading. In addition, we prefer to tell

our traders to use stop loss every time. In the fixed fractional position sizing,

we are only risking the certain percentage of our trading capital per each

trade. For example, you can risk 1%, 2% or 3% of your trading capital for

each trade. Sometimes, it is common to use the value smaller than 1% in

some fund management company like 0.5% per trade because they are

running large capital. The choice of the value is depending on your risk

preferences, your trading experience and your capital size. For starters, we

recommend to use less than 2% most of time. To use the fixed fractional

position sizing, you must know the size of stop loss for your trading. If your

trading strategy does not have stop loss size, then you may have the problem

of calculating the fixed fractional position sizing. Then you have to use the

fixed position size. The formula to calculate the fixed fractional position size

is like this:

Position Size (Lot) = Account Risk in dollar / (Stop Loss Size in pips * pip

value) where the Account Risk in dollar = the risk % x your trading capital

(US dollar).

The steps to calculate the fixed fractional position sizing is like this:

Determine Stop Loss Place and calculate the stop Loss Size in your

chart

Determine the Risk % of your trading capital

Evaluate pip cost and calculate lot size for the given Risk %.

We illustrate a live trading example for better visualization of the process.

Consider that we want to trade on AB=CD pattern at the median open price

on EURUSD. We will place our stop at the lower pattern completion interval.

This gives us 25 pips for our stop loss size. If we want to take 1% risk for our

10,000 US dollar trading capital, we can calculate our lot size for the 1%

trading risk assuming the pip value is 10 US dollar like this:

0.4 Lot = 100 / (25 * 10) where Account risk 100 US dollar = 1% x 10,000

US dollar.

For your live trading, it is much wiser to use the automatic calculator to get

the exact trading volume efficiently.

Figure 10-1: Example trading on AB=CD pattern on EURUSD.

Trader can use the position sizing using the Kelly’s Criterion. If the fixed

position sizing and the fixed fractional position sizing uses the constant risk

criteria throughout your trading, the risk is not constant any more in the

Kelly’s Criterion. In the Kelly’s Criterion, the risk is depending on the Win

rate and Rewards/Risk ratio of your trading strategy. With Kelly’s criterion,

your risk % will increase if you get better trading performance. Your risk %

will decrease if you get worse trading performance. One important caution

about Kelly’s criterion is that the Risk % calculated with this formula might

be too aggressive for your trading. Therefore, you might use the half or a

quarter of the risk % calculated from the Kelly’s Criterion. With Kelly’s

Criterion, you do not need the stop loss size but you just need to measure the

size of average profit and loss from your historical trading.

Kelly’s Risk % = W-[(1-W)/R] where W = Win rate and R =Reward/Risk

ratio.

10.3 Reward/Risk Ratio in your trading

In any trading and investment, you need to know what your potential Reward

and Risk are. Trading and investment involves many form of risks. With

these risk factors, your winning rate will be subject to probabilistic nature.

The Reward/Risk ratio is the single most important quantity to deal with the

probabilistic nature of our trading outcome. The ratio is simply calculated by

dividing the average profit by average loss. If your trading strategies have the

stop loss always, then you can calculate the Reward/Risk ratio straight away

from dividing the take profit size by the stop loss size. If your trading strategy

does not have the stop loss, then you need to find your average loss and profit

from the historical trading results. In any case, you should calculate

Reward/Risk Ratio. Some trader might use the Risk/Reward Ratio instead of

Reward/Risk ratio. Both are identical except the position of numerator and

denominator is reversed. I personally prefer to use Reward/Risk ratio because

I have to work less with decimal places. It is also easier to communicate with

the Reward/Risk ratio with other traders for the same reason. For example,

we recommend using Reward/Risk ratio greater than 3 for the Harmonic

Pattern trading. The number 3 is intuitive and it is informative too. It simply

means that your take profit size is three times bigger than your stop loss size.

Instead, consider the cases where Risk/Reward ratio is used. Now you have

to tell other traders that your Risk/Reward ratio is 0.333. Although

Risk/Reward Ratio 0.333 carries exactly same meaning with Reward/Risk

ratio 3, 0.333 is much harder to be interpreted every time in our trading.

In this section we assume that your trading strategy have the predefined stop

loss and take profit size before your entry. In fact, this is recommended

practice to average trader although this is not compulsory because there are a

lot of trading strategies controlling risk by other means. Along with the

Reward/Risk ratio, you need to be able to derive some other useful

information frequently for your trading. Firstly, you should be able to

calculate your profit and loss quickly based on your Reward/Risk ratio and

your Risk %. It is important because trader should have a feel about the

number in their trading. If you risk 1% of your trading capital for each trade

with the Reward/Risk = 3, you will be making 3% on your win and you will

lose 1% on your loss. If you risk 2% of your trading capital for each trade

with the Reward/Risk = 3, you will be making 6% on your win and you will

lose 2% on your loss.

10.4 Breakeven Success Rate

From your Reward/Risk ratio, you should be able to calculate the breakeven

win rate. Breakeven win rate is the ratio of your winning trades to your entire

trades in order to break even in your trading account. Breakeven win rate can

be calculated using the formula below.

Breakeven win rate (%) = 100 * (Stop Loss Size/(Take Profit Size + Stop

Loss Size)).

For example, if you have 30 and 30 pips respectively for your stop loss and

take profit, then your breakeven win rate is 50%. The breakeven win rate

50% means that you need to win 5 out of 10 trades for you to break even in

your account. For the Reward/Risk ratio = 1, any excessive wins after your

5th win will contribute to your profits. Figure 1-2 show the corresponding

breakeven win rate for the given Reward/Risk ratio. When you have the

Reward/Risk ratio = 3, your breakeven rate is 25%. This means that you can

breakeven in your trading if you can win 25 times out of 100 trades or 2.5

time out of 10 trades. For the Reward/Risk ratio = 3, any wins after 3rd win

will be your profits.

Risk Reward Breakeven Win Rate %

100 1 99%

50 1 98%

20 1 95%

10 1 91%

51 83%

41 80%

31 75%

21 67%

11 50%

12 33%

13 25%

14 20%

15 17%

1 10 9%

1 20 5%

1 50 2%

1 100 1%

Table 10-4: Breakeven win rate for various Reward/Risk ratio.

Often I met many starters who believe that they need the win rate of 70% or

over to be successful for their trading. Now you can tell that this idea is

definitely wrong. How many of you have pursued the trading strategy with

high win rate like 90% or 95% and blown up your account? If your reward is

exceptionally small comparing to your risk, then you can always manufacture

such a high winning rate system. Those systems will produce the

exceptionally smooth balance curve upwards at the beginning until it start to

lose its edge. Such system is normally not profitable in the long term. If the

Reward/Risk ratio <= 0.1 (i.e. Reward =1 and Risk=10), you will typically

need to achieve over 90% of winning rate to just breakeven. When you make

one loss in your trading, you will need high trading frequency to breakeven

after the loss. This will definitely add a lot more work on your trading. In the

human trader point of view, it is better to stick with Reward/Risk ratio >= 1.

10.5 Know your profit goal before your trading

Calculating your profit target before your trading is very important task if

you want to become a successful trader. Calculating your profit target helps

you to see what factors can influence your profitability. Once you have

identified important factors for your profit calculation, you can have a

realistic view on your profit. This helps trader to stop gambling with your

trading. Practically I have found that the trader, who trades without knowing

their profit goal prior to their trading, often fails miserably.

Especially when you apply new trading strategies, it is difficult to know its

potential profitability. For this reason, it is easy for traders to give up the

trading strategy after they are hit with few bad trading. However, if you can

calculate the potential profit from the strategy before using them, you are

likely to stick with the trading strategy until you will achieve the profit goals.

With the set profit goal, you can improve your discipline much faster. To

project the future profit in advance, you can use the hypothetical profits

formula I have created. I often use this hypothetical profit formula to get

some idea about the profitability before trading. With this calculation, you

will see why knowing your reward/risk ratio is important.

Hypothetical profit for N trades = Hypothetical profit per trade x N trades.

Where Hypothetical profit per trade (US dollar) = Reward per trade (US

dollar) x Win rate – Risk per trade (US dollar) x (1-Win rate).

Before using this formula, trader must know that this formula is accurate for

the fixed position sizing. If you are using this formula for the case of the