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Measuring
Reward: Risk
| Why do great trade setups fail, while lousy ones move
in our favor? The answer is quite simple, yet
frustrating. Trading is an odds game, in which anything
can happen at any time. Price will go where price wants
to go, no matter how hard we hit the books, study the
charts or pray to the deities. So rather than searching
for the perfect trade, we're better off learning to
control risk first. |
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You've forgotten the nature of risk if you can answer
"yes" to any of the following questions. Do you still
buy "how-to" books, even though you've traded for years?
Do you sit in bad losses because you hate to be wrong?
Do you reject market wisdom because you lost money
trading it?
Measure reward:risk before taking a trade, and let it
guide your open position. Price close to good
support identifies a low-risk long setup. Price
close to substantial resistance identifies a
low-risk short sale. The distance between your
trade entry and the next obstacle within your
holding period measures the reward, and intended
exit. |
| The distance between the entry and
the price that breaks the trade points to the risk, and
unintended exit. Put the odds firmly in your favor by
only taking trades with high reward, and low risk. The best swing trades exit in wild times, just as
advancing price approaches a strong barrier. Reward
planning seeks discovery of this price before trade
entry. This profit target sits at a level where risk
will increase dramatically when price reaches it.
Traders should exit immediately once this profit target
is struck, or at least place a stop that locks in
profit, in case of a reversal. |
Every setup has a price that busts the trade. The safest
trades need only a small move to signal a bad outcome,
and the need to jump ship. This loss target changes
dynamically after entry. Consider the impact of the last
price bar on evolving reward:risk, and adjust the plan
accordingly. Many traders find it difficult to absorb
new information quickly. So they're better off sticking
with the original plan, and using trailing stops to
protect the position.
How do you know the price that kills the trade? You'll
find it at the convergence of support-resistance
boundaries on your setup. These usually turn up through
combinations of violated moving averages, broken
patterns and filled gaps. Every situation is different,
so finding the loss target may require all of your
trading skills.
Exit swing trades to book profits, take losses or
close mediocre positions. A good exit is more valuable
than a great entry. Emotions usually run high at both
reward and risk targets. So take a deep breath and clear
the mind before closing out a position.
Tips on Reward:Risk Management
- Watch the clock and become a market survivor. Market
cycles affect price movement in many ways.
- Exploit market quirks in your entries and exits.
Events like overnight gaps and options expiration can
benefit positions, rather than hurt them.
- Enter smaller trades when signals don't line up well.
Good timing on bad stocks makes more money than bad
timing on good stocks.
- The best signals converge through many different types
of technical analysis.
- Use common sense and good mathematics in your profit
and loss projections.
- The most profitable entries and exits come when the
crowd is leaning the wrong way.
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