Hello traders! This week’s article will discuss why we are attempting to enter our trades as close to the turn in price as possible, thereby giving us a solid reward to risk ratio.
First off, we need to define our reward to risk ratio. Your reward is how much you expect to make in a trade, and your risk is how much you are willing to lose to take this particular trade. At Online Trading Academy, we recommend traders take trades that offer at least a 3:1 reward to risk ratio. Essentially you are willing to risk (for example) 10 pips to make 30 pips. There are a couple reasons we recommend this, the first is that you will be selective in your trades! One of the important rules in trading is that we are paid on the quantity.I would rather take fewer, better, trades than more bad trades. The second reason we recommend this 3:1 ratio rule is that a trader can lose money on three trades, make money on the fourth, and come out at break-even. Over time, we do expect traders to make money on more than one trade out of four! Plus, when you get good at managing your winning trades, your actual realized profits may exceed your initial reward of the 3 in our ratio. (See my previous newsletter for suggestions on how to do this here).
Next, what does the turn in price look like? In the following chart, a supply zone for a short entry was highlighted with the yellow box, and the blue arrow indicates where a good short trade could have been entered. This is the expected “turn in price.” As discussed in previous newsletters, our stop would go above the zone in which we entered. Here it would have been about 17 pips. Using our 3:1 ratio, we need to find a reasonable profit target of at least 3 times that, or 51 pips. The blue box shows a small demand zone fulfilling our 3:1 ratio, while the green box give us a target of 72 pips, giving us a potential 4:1 trade.
So the turn in price would have been in the supply zone, at the blue arrow giving us a simple 3:1 reward to risk ratio, if not better if the trade kept running. But where do most new traders look to enter? The interesting this is that many trading books teach traders to take what we call a “break-out” trade. This is where price breaks down below a support level, or above a resistance level. This is usually far, far away from the turn in price! The short blue line marked “B” is a common entry used by new traders. In this example, the trade would have worked out entering there, but where would the stop go? If done properly, the stop would still be in the same place as the trade entered at the supply zone. What happens to the reward to risk ratio when entering at the breakout price? Entering there at approximately 136.95 would have given you a 44 pip stop, and a profit target of 26 pips at the blue box and 45 at the green. Over time, this strategy will make you a very frustrated, unsuccessful trader.
Please keep in mind that many of the rules we discuss in our Lessons From the Pros newsletters, and also in our classrooms, work out over time and many trades. Any one individual rule might be broken and work out a few times. One example in real life is speeding in your car. If you have a short trip and you are traveling over the speed limit by a few miles per hour, most of the time you won’t get caught. Have you ever considered how much actual time you are saving vs. the amount of time you would lose by getting a ticket, and how much the ticket would cost? On a short ten minute drive, the time saved is mere seconds – maybe a minute! But getting stopped might take 20 minutes, and cost $100 or more. Are those few saved seconds (your reward for speeding) worth the risk of a 20 minute stop and a large fine? Logically, the answer must be no. The same thought process should be applied to your trading. Breaking a rule here or there might work out for a small profit. But it is the large or frequent losses that will accumulate that make these rules so powerful! Getting 50 speeding tickets might cause you to lose your license to drive, and 50 large losses from breaking the rules might mean you aren’t a trader anymore!
So there you have it. Trading at or near the turn in price gives you better reward to risk ratios, and combined with proper trade management can turn trading into a profitable journey instead of a hobby. You do know what people who trade as a hobby are called, right? We call them “donors.”
Until next time,