Guide to Precision Harmonic Pattern Trading(191)

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