In this episode of Truth About FX, Walter talks about the profit bricks method and how to overcome your psychological barriers. He also reveals some useful tricks on how you can make those losers work and turn them into profitable trades.
Download (Duration: 05:45 / 13.8 MB)
In This Episode:
00:36 – mathematical guideline
02:00 – four possible results
04:52 – how it differs from normal trading?
06:00 – a tradeoff
08:07 – be aware of probabilities
10:22 – independent events
12:13 – Monte Carlo simulation
Announcer: Sometimes, forex trading is a wild and wooly place to be. That’s why Hugh is here, to post your questions to Walter, the naked forex guy. Hugh’s got questions and Walter’s got the answers. Here at the Truth About FX Podcast.
Hugh: Hi, Walter. I read your book “Risk Management” and it’s excellent. The thing that stuck out the most in that book to me was the Profit Bricks method. Could you talk a little bit about that and is there a mathematical guideline as to when that will help you and when it won’t?
Walter: It’s more of a psychological barrier, I think. Great question, by the way. This is something that we’re talking a lot about in our Inner Circle group. A lot of people are trying to wrap their head around it and the reason why is it’s uncomfortable.
I believe as many traders believe that sometimes, we have to do the uncomfortable things to improve our trading. I think that’s part of what goes on with Profit Bricks. But, just for people who do not understand it, I’ll quickly explain.
Let’s say that you have a trading system and it’s a 3 to 1 reward to risk ratio. You are risking 1% to make 3%. You are risking a 100 pips to make 300 pips or whatever. Let’s also say that you have a 30% win rate with that strategy.
It has a positive expectancy, of course, because it is above the 25% mark and you could just trade it normally and you could make money. But, here’s where it gets really interesting.
Let’s say that I’m trading the strategy and I am just trading it normally. I’m risking 1% or whatever. If you’ll look at your trades at the two-trade level — a two-trade increment which is what Profit Bricks is all about. If you think about it, there are really only 4 possible results.
Number one is that you have a loss and then that is followed by a loss. Now, obviously, if you’re risking 1R on any given trade, you’re going to end up -2R after that sequence. In this scenario that is going to happen 49% of the time.
The reason why it’s 49% is to get the probability of something happening. You just multiply the probability of it happening by itself. So 70% of the time, I have a loser multiplied 0.7 x 0.7 then I’ll get 0.49.
I know that 49% of the time, I’m going to get a loss followed by a loss. Now, 21% of the time, I’m going to get a loss followed by a win. When that happens, I am going to make 2R. Why? Because I lose 1R on the first trade and I make 3R on the second trade, the sum of these, I make 2R.
The next result is that you can have a win followed by a loss. Again, you are going to get the same result because you are going to have a 3R result: a +3R and then you’re going to lose 1R so you’ll end up +2R on that sequence. Again, it’s going to be 21% of the time if that happens.
Finally, you have the best situation which is a win followed by a win. Obviously, if you are making 3R on your winners, that is going to give you 6R. If you look at this from a two-trade point of view — let’s say that we’re looking at a 100 trades. Really, we are looking at 200 trades but we’re clamping them in groups of two.
What we would expect over that sequence of trades — which we’re calling a 100 trades but which is really 200 trades but we’re clamping them together. You are going to end up — if you do the math and trust me, you could do the math and you’ll find — you are going to make 94R.
The reason why is because 49% of the time, you lose and you lose 98R. Then 21% of the time, you gained 42R. The other 21% of the time, you gain 42R. And then finally, the 9% of the time you get a 108R. You add that all up and that gives you 94R.
Now, let’s look at Profit Bricks. The exact same result will happen when you start off with a loser because with Profit Bricks, you’re just taking the winnings and your adding that to the next trade.
With a loss followed by a loss — which happens 49% of the time — you’re going to lose 2R, just as you would normally. With Profit Bricks, a loss followed by a win, you are going to gain 2R again because it’s just like the normal way of trading.
But, if you start off with a win then you add that winnings plus your normal risk amount — which is in this case 1R — and you risk all of that. If we’ll start off with a win, we win 3R and then the second trade we’ll risk that 3R and we will risk an additional R so we’re risking a total of 4R.
If we lose, we will lose all 4R which means if we have a win followed by a loss, we’re down 1R. We’re down negative 1R and that’s where it differs from normal trading because, of course, in normal trading when that happens, a win followed by a loss, it would still be up 2R. That’s the tradeoff with Profit Bricks.
Here’s where it gets interesting. If you have a win followed by a win — again this is the least likely scenario that happens with the least frequency but it pays off quite nicely. If you have a win and you win 3R, you take that 3R, you add another 3R to it and you risk that additional R so you’re risking 4R and you get your 3R payoff.
Guess what? Now, you’ve made 12R. In that two-trade sequence, you made 12R. Again, you also get to keep that 3R you’ve made on the first trade so you actually made 15R. If we can pair that to the normal trading, what do you get when you get a win followed by a win? You get 6R.
The difference in Profit Bricks is really this. The question is when you have two winners, would you rather have 15R knowing that the tradeoff is if you have a win followed by a loss, you won’t get to keep that 2R but instead you’ll lose 1R? It’s basically a trade-off of that. Will you take that 15R instead of 6R knowing that sometimes you won’t get that 15R? You’ll just lose 1R.
The way I like to look at it is you’re basically at taking a 1 to 15 trade. That’s basically what it is but they only happen as frequently as your win rate multiplied by itself. If you have a 30% win rate, in this case, it’s only going to happen 9% of the time so it’s not going to happen that often.
Here’s what would happen if you had a 1R strategy where you risk 1R and you gain 1R. You’ll probably be going to end up about the same as where you would be normal and it’s not really worth it to trade it. If you have a really, really low R like below 1R, I probably would not trade it at all.
It probably best going to be for those traders who either have a really high win rate and a better than 1 to 1. Or, you have a really high R and you’re willing to sit through the bad times which is basically, you have a winner followed by a loser.
I don’t want to totally confuse everyone but that’s basically the gist of it and where it works. What ends up happening is you have to train yourself to be okay with those equity curves and I’ll post it in the show notes so everyone can see. You have to train yourself to be okay with those equity curves where they jump up really fast, really quickly and then it kind of makes a little flag down. That’s your drawdown.
It’s almost like a trending chart. When the market goes up really strong, and then makes a bullish flag and it drifts down, and then makes another strong move up that is kind of what your equity curve looks like when you trade Profit Bricks.
That is very different from the sort of up and down, almost a 45-degree angle that most traders are used to trading or want to trade. It takes a little bit of getting used to it if you’ll do this.
Hugh: Yeah. I actually took my first Profit Bricks trade today and it’s a little scary, to be honest.
Hugh: But with backtesting, it helps you get used to this kind of thing.
Walter: Totally. And also, you just need to be aware of the probability. You can get really aggressive with it. If you have a 3 trade profit brick ,like in the same situation we’re talking about here, then you’re only going to win 2.7% of the time. You just have to be aware of that.
When you do your backtesting, you want to make sure if you use a 3 trade brick. What that means is you will get a payoff 15R plus 49R so that’s 64R. The 64R payoff, which is amazing, but it’s only going to happen 2.7% of the time on average.
If you’ll only take 50 trades and you test it and you go, “This sucks”, just know that you probably need more data to know exactly what it’s going to look like. As you really push the limits, you need to really reduce your risk so you’re able to withstand those drawdowns. Otherwise, you’ll run out of capital.
It’s just one of those situations where it’s like, how far do you want to push it. You could be trading a situation where you get maybe 15 trades out of 1,000 then hit it but they have this amazing like 900R payoffs or whatever. That’s great.
But, if you trade 700 trades and you never hit your winner, are you out of capital yet? You know what I mean? 700 losers in a row, that sort of thing. That’s the thing that I think you keep in mind if you want to test this. You need to remember what your odds are.
The backtesting will help but I think you need to understand probability which is really simple. If you want to know the probability of a sequence of events, you just multiply the probabilities.
For example, I’ve been using… I’ve been multiplying two different probabilities: 70% chance of a loss and 30% chance of a win. Once you have those numbers, you can multiply that out and figure out what other different probabilities are going to be. That can enable you to figure out what to expect in your backtesting.
The other thing that I know is that some traders trade systems where the winners tend to clump together. If that is the case, this could be pretty good for you because the probabilities can actually change.
It may not actually be completely independent events. We’re assuming that your trades are completely independent events, in which in most systems, that’s the case. But if you trade like some sort of a trend trading system, where you add onto a trade and keep going forward, some sort of a trailing exit and your winners clump together when the market is trending, what you might find is that this is even better than you would expect by normal probabilities.
I wouldn’t count on that but that could be the case so that is something to keep in mind as well. Some traders will find that when they test it and they have a trailing exit that it doesn’t do very well and that could just be bad luck. Because. If you think about it, let’s say, you take a trade and your trailing exit gets you out at 2R on the first win you’re like, “It’s sweet.”
I’ll take that 2R and then I’ll add it to my 1R for the next trade. I’m risking 3R on my next trade. Guess what? That might only get you .5R before the trailing exit pops you out. Do you know what I mean?
If it makes 0.5 times 3, it is making 1.5 so it actually made less than the first trade did. You actually have quite a bit of a risk in there if you think about in terms of R. That is the other thing to keep in mind. I like it with strategies that have hard targets. I’m not saying that’s the best. I’m just saying that at least then you’re reducing the viability of your winners because it can penalize you.
Profit Bricks can penalize you if you use a trailing exit and you just get unlucky and your second winning trades are not as fat as the first ones. That’s the way it ends up. You could get into trouble.
Hugh: I know somebody is going to ask this so, I’ll ask it here. What about a Montecarlo simulation with Profit Bricks? Will that help you at all?
Walter: What you want to do is you want to simulate the sequence. You just have to remember what you need to simulate are the two-trade, if you are using two-trade bricks you could use the three, four or five. What you really want to keep in mind is you need to simulate at the trade level and the more we’re using Profit Bricks, we’re changing our perspective. That is why when you have a winner, you cannot count it as a winner. It’s half a trade done.
It’s like when you have a trade and it hasn’t hit your target but it looks like it’s going to, that’s where you’re left at. So, just keep that in mind you can do Monte Carlo simulation. The mistake people end up making is they do the Monte Carlo simulation at the trade level which is what they normally used to.
You’ve just got to keep in mind that there are four if you’re using the two-trade bricks, there are four possible events: Loss-loss; loss-win; win-loss and win-win. You need to make sure that you simulate those distributions. Otherwise, you’re going to like, garbage in, garbage out sort of situation like passing classic result. Just remember that you’re looking at trades from the two-trade level.
Obviously, you can do three-trades, four-trades, five-trades. It’s just that the probabilities go way down and R goes way up. You’ll be amazed at how quickly the R goes up actually but also how infrequently you’ll hit those.
Hugh: Okay, cool. That is awesome. Thanks, Walter.
Walter: Great question. Thanks a lot.
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