In this issue, we will discuss in detail “one important indicator” that is essential for obtaining excellent trading techniques.
Knowing this indicator will enable you to do the following, which will take your verification to the next level.
- You will be able to see numerically how much advantage you have in your trading methods.
- You can objectively compare and verify the superiority of various trading methods.
- You will know the conditions necessary for low-risk, aggressive trading.
Please read this article to acquire this knowledge.
Reliability Factor, a measure of superiority
The name of the indicator – which determines how much advantage a trading method has – is called the Reliability Factor.
It is the ratio of the maximum drawdown to the total profit in a month. First, look at the profit/loss graph below.
The total profit of a trade increases with repeated drawdowns along the way.
By looking at the ratio of the size of the drawdowns to the total profit, we can objectively determine whether a trading method is one that steadily increases profits or one that fluctuates (falls) sharply.
By looking at this number – the Reliability Factor – we can judge and verify the superiority (in this case, reliability) of the trading method.
The higher the Reliability Factor, the more stable and profitable the trading method is.
This indicator literally means “reliability of the trading method.
*If you are not familiar with drawdown, please refer to the following article for a detailed explanation.
Cases with “high” Reliability Factor
Let’s look at a typical profit/loss graph for a high Reliability Factor.
The figure above is a case with a high Reliability Factor – that is, the maximum drawdown is small compared to the total profit in a month.
Even if the margin decreases temporarily due to losses on a trade, it does not have a significant impact, and the total profit increases again to the previous maximum value, which is a high advantage.
As a concrete example, I will show you a graph of ForexTester’s profit and loss when I was testing the trading method in the past.
*Click to enlarge.
The ratio of average profit to average loss is about 2:1 or more, which means that a small loss is established on a small scale (in effect, a small profit to a small loss).
Therefore, although the winning rate is not very high and there are many consecutive losses, the maximum drawdown is very small as a result of keeping each loss small.
Helped by the market conditions at the time, the Reliability Factor was an outstanding 27.33.
The basic attitude should be “improve low Reliability Factor values”.
Imagine here, how do you think you feel when you are repeatedly making trades in the forex market that result in this kind of profit/loss graph?
- If you keep on losing, your profit will start increasing again soon.
- If I continue to follow the current trading rules, I am sure that my profits will increase without a serious decrease in my capital.
In this way, you will feel less depressed about one losing trade or losing streak, and you will feel “confidence” in your trading methods, just as the word “reliability” means.
Cases with “low” Reliability Factor
Now let’s look at the opposite case, where the Reliability Factor is low.
You can see that the maximum drawdown value accounts for more than half of the total profit for the month, making the profit/loss graph as unstable as it looks.
As another concrete example, I will show you the profit/loss graph of ForexTester2 when I was testing the trading method in the past.
*Click to enlarge.
Looking at the overall picture, there is a total profit, and at first glance, the graph shows a steady and seemingly steady rightward movement. There is no doubt that this trading method has certain advantages.
However, if we look at the profit per month and the maximum drawdown, we can see how unsound it is (the Reliability Factor is only 1.18).
We can also see that it takes a long time to get out of a drawdown, and that even after getting out, the growth in profits is slow.
As before, imagine how you feel when you repeatedly make trades in the forex market that result in this kind of profit/loss graph.
- “If I start losing again, won’t I just go on a losing streak and never win again?”
- No matter how much profit I accumulate, I’m going to spit it out again. ……
- “I’m just tired of losing all my money.”
As a result of these feelings, even if a trading method has the advantage of winning in total, you will have a hard time continuing to use it.
In other words, you will be in a state where you cannot trust the trading method.
How high a number is desirable?
It is difficult to say how much more than a Reliability Factor value is desirable, since it depends on factors such as the period of time covered.
However, as a guideline, I consider the following guidelines to be effective.
Reliability Factor Guidelines
- If it is less than 2.0, you may experience mental difficulties in continuing to trade forex, even if you have an advantage and are profitable.
- In order to overcome a little trouble and maintain total positive results, the Reliability Factor should be at least 3.0.
- If it is around 5.0 to 8.0, it is possible to continue trading stably and profitably while experiencing an advantage.
- If the Reliability Factor is 10.0 or higher, aggressive trading with large position sizes and compound interest management will be possible.
This is because a small number of trades will not give an accurate number, and too long a period of time is likely to give a large number.
Advantages of having a high Reliability Factor value
Trading methods with a high reliability factor have the following advantages
- Even if a small number of consecutive losses occur, the trader can continue to trade forex with psychological stability without doubting its superiority.
- It allows you to trade with larger position sizes, which increases your financial efficiency (i.e., the speed at which profits increase).
The psychological benefit of “1” is that, as explained earlier, the impact of drawdowns is smaller than the total profit, so “the feeling of losing a single trade or losing a series of trades becomes lighter (less pressure).
Next, let’s discuss the “2” advantage in detail.
Can increase the speed of profit growth
A high Reliability Factor allows for a larger position size. What does this mean?
For example, if you double the size of your position, the amount of loss when you cut your losses will also double.
In other words, the larger the position size, the faster your money will decrease.
Therefore, in Forex, the money management rule is to limit the amount of loss to 1-2% of the margin at a time to avoid excessive risk from large positions.
However, if you have a trading methodology with a high reliability factor, you can trade aggressively with large position sizes.
Smaller maximum drawdowns relative to total profits per period mean that a series of losses or unexpected losses will have a smaller impact on margin.
Therefore, there is room to increase the risk per trade.
The chart below illustrates this.
The light blue graph shows the profit/loss graph for the trading method with a high reliability factor, and the blue graph shows the profit/loss graph for the same trading method with an increased position size.
Although the absolute amount of drawdowns has increased, we can see that the margin has increased significantly without collapsing.
Needless to say, we need to be very careful about this “absolute amount of drawdown increases.
So, to give you a sense of the risk of increasing the absolute amount of drawdowns, let’s look at the case of a trading method with a low Reliability Factor, where the position size is increased to try to increase the speed of profit growth.
The light blue graph shows the profit/loss graph with a low Reliability Factor, and the blue graph shows the same trade with an increased position size.
It is true that the final total profit is larger, but in the middle of the trade, the margin has gone negative and the trade has collapsed.
This is the result of doubling the accumulated loss at the time of drawdown due to the larger position size.
Even if margins did not collapse, the lack of margin maintenance ratio in a situation of large drawdowns makes it possible to enter only with a position smaller than the original position size.
The smaller position size resulting from insufficient margin means smaller profits, and it takes many times the normal number of trades to recover from a drawdown.
This chart clearly shows the risk of easily increasing the size of a position just because of the superiority of the trading method.
At the same time, you can understand the advantage of high Reliability Factor.
Advantages of Using the Reliability Factor in FX Verification
The Reliability Factor allows for an objective evaluation of the superiority of a trading method and has the following advantages
Advantages of Using the Reliability Factor in Verification
- Avoid having to keep improving (adjusting) your trading methods forever.
- You will not get lost in the search for the Holy Grail, saying, “There must be a better method.”
It is basically the right approach to “try to improve our trading methods to be better than they are now.”
However, if you keep adjusting the rules without a clear evaluation indicator, it is like a race without a goal, and you will keep tinkering with your trading method forever.
If you tinker too much, you may end up losing the original advantage and end up saying, “Maybe it would have been better to leave it the way it was in the first place. In addition, adjusting the trading rules itself is not a simple matter of adjusting the trading rules.
Moreover, adjusting the trading rules may become an objective in itself, and you may end up in a situation where time is running out.
With the Reliability Factor, you can avoid getting lost in the labyrinth of trading method adjustments (the search for the Holy Grail).
The Reliability Factor is a useful indicator that makes it possible to evaluate the superiority of any trading method with a single indicator.
Of course, it is not a panacea, but it is certainly a very useful indicator to fulfill the objective of continuously making profits in trading.
When used to improve (adjust) trading methods
When trying to improve results by adjusting a trading method in Forex, one should compare the Reliability Factor before and after the adjustment and note how the value has changed.
If the number of trades increases and the total profit (pips earned) increases as a result of the adjustment, but the Reliability Factor drops significantly, it may not have been a favorable adjustment.
This is because, for example, the total number of trades and total profit may have increased as a result of a change in the rule to “force entry even in unprofitable market conditions.
Therefore, if a period of time comes when the trading rules do not mesh, it is highly likely that the drawdowns will be larger than the rules before the adjustment.
Furthermore, if they are not properly applied, the advantage may disappear at certain times of the year.
The preferred approach to improving a trading method is to adjust it so that the Reliability Factor is higher, even if the total profit is lower.
Trading with increased position sizes with this adjusted rule will result in more consistent profits than with the previous trading rule.
When used for comparative verification of trading methods
When comparing and verifying various trading methods in Forex, it is often the case that the profit per month (pips earned) of each trading method is used for comparison, but this is problematic.
To take an extreme example…
- With a large position to the limit of leverage,
- Keep persisting with a large stop-loss margin,
- Profit by being lucky enough to ride the trend.
Even with these trading methods, the apparent gains can be large.
In reality, however, the drawdowns tend to be large because large losses are inevitable, and the large size of the position also exposes the margin to excessive risk at all times.
Therefore, in the long run, this may actually be a trading method with little advantage.
On the other hand, the following seemingly trivial trading methods can be powerful in terms of the reliability factor.
- Identify the few trading opportunities,
- Repeat a small loss and a not-so-large (small) profit.
These trading methods tend to produce smaller pips per period.
However, they tend to have a high Reliability Factor, which allows them to increase the size of their positions with lower risk, thus increasing the amount of money they can earn.
The Reliability Factor is a measure that allows us to compare the superiority of trading methods in this way.
With ForexTester, it shows up on the statistics screen
The Reliability Factor described in this article is displayed in the statistics screen as standard in ForexTester.
Therefore, you can always observe the statistical results in your FX trading practice to check the reliability of your trading methods.
It is recommended to use ForexTester because it is useful for comparing trading methods.
Two types of dominance (reliability) indicators are available in ForexTester.
- Reliability factor: value per month
- Restoration factor: Value for the entire validation period
The Reliability Factor, in particular, provides an indicator based on the “estimated profit for one month” calculated based on the statistics at that time, even if the verification period was less than one month.
Therefore, when using rules with a large number of trades, you can get an accurate Reliability Factor even from the results of one week of trades, making comparisons and adjustments much easier.
For more information on ForexTester, please refer to the following article.
Related Forex practice software “Forex Tester”, a classic & recommended forex practice software
How to evaluate and verify the superiority of a trading method – Summary
As an indicator to evaluate and verify the superiority of a trading method, it is useful to divide the “total profit in a month” by the “maximum drawdown.
This is called the Reliability Factor (or Restriction Factor).
The higher the Reliability Factor, the more stable and profitable the trading method is.
It is a very useful indicator when comparing multiple trading methods and when making adjustments and improvements to a trading method.
By understanding the Reliability Factor, we can maximize the position size per trade with low risk, thereby increasing our financial efficiency.
This article explained how to verify the superiority of a trading method and introduced some important forex indicators.
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