Reward/Risk Ratio – III

  1. Last week we considered the Reward/Risk Ratio as a way to stack the trading odds in our favor. That is, the reward side of the equation measures how much we expect the price to increase. The risk side asks the question, how much can we lose if the price move doesn’t go in our favor. So, there’s an up-side and a down-side to every potential trade. By setting up trading conditions so the reward is higher than the risk, over time we will make more than we lose. We’ve pushed the odds to our side of the table. On the other hand, if our losses equal our wins, its about a wash. The R/R ratio quantifies this relationship; Reward/Risk = R/R ratio. If our reward is twice the risk, our ratio equals 2.

  2. The reward, or potential increase, is a subjective judgment each trader has to make. Often, as in our example last week, this judgment is based on past support and resistance levels. Let’s review that with another pick made on 2/28/03, EYE.


    Fig. 1

  3. Two obvious resistance levels are shown with the dashed line (at $10.30) and at the dotted line (at $9.30). That’s a $1.05 reward at the dotted line or $2.05 at the dashed line. To define the risk, we need to set a stop-level, or where we want to bail-out if the move turns south. Last week we used the same technique for the stop-loss as we did for the reward; look for natural past support and resistance levels. This week, we will introduce the Average True Range (ATR) as a way to limit the down-side.

  4. The Range is the difference between the high and low price for a trading period (minute, hour, day, week, month). We pay close attention to opening and closing prices, but scant attention to the daily trading range. However, this information can provide helpful clues to market behavior, particularly with regards to how much variation might we expect during normal trading periods. That is good info when setting stop-loss points, low enough to not be kicked out by noise, but close enough to maintain as much of our capital as possible if the move is down. The range is a measure of market noise.

  5. The simplest measure of range is the high price less the low price. The average range is a stronger indicator of the price dynamic.


    Fig. 2 Price Range . . . . . . . . . Fig. 3 Five-bar Average Range

  6. In this example, the five-day average of 5.2 gives a general idea of the range during this period. However, with greater volatility, we must consider changes from one day to the next as the following figure illustrates.


    Fig. 4 “True” Range = The Greater of the three options

  7. The True Range (TR) is defined as the greater of the three choices. For example, in case (c), a gap between price bars clearly increases the range between highs and lows. However, the better limit for both (b) and (c) is the open as shown, not the top (or bottom) of the first price bar. A summary of the rules for true range are:

    The greater of:
    • The high for the price bar minus the low for the price bar.
    • The close for the previous price bar minus the low for the current bar.
    • The high for the current bar minus the close for the previous bar.

  8. An average tells how consistent the TR’s remain at a particular value. That is, an Average True Range (ATR) give us a measure of the variation within the high-low channel during normal trading activity. The number of bars used in the average is rarely more than 15, with half that number common. If too many bars are used in the average, the ATR becomes less reflective of current market action. In the spread sheet shown, the ATR is calculated using a 10-day average of the True Range. We see on the day in question, 3/28/03, the ATR is 0.38.


    Fig. 5

  9. Using this value for the ATR, $0.38, specifying a stop at twice this value, our stop would be the closing price less twice the ATR: Stop = $8.25 – 2x$0.38 = $7.49, with a risk = $0.78. That makes the R/R ratio = $1.05/$0.78 = 1.35, or with the more optimistic reward, R/R ratio = $2.05/$0.78 = 2.63.

  10. Moving ahead to the current day, we find the low price on any day did not get down to the stop ($7.49), though it did fall a bit from the buy on 3/28.


    Fig. 6

  11. This ticker was a good pick, so far. Next week we will consider exit strategies, to see just how much of our profit we’ll be able to keep. But lets reflect on this week’s example. The task: Consider using a Reward/Risk ratio as an entry criteria to increase profits. Sounds easy enough, but it is not a “system” to solve all our problems. We had to exercise judgment, where to place the possible price target to get a “Reward,” what multiple of the ATR we should use for the stop loss to get a “Risk,” and what R/R ratio to use as entry criteria. But, you ask, what are the right ones? And as you ask, you know the answer – you must provide the answers yourself. This GP provides a framework for the judgments to be made. We will provide trading methods with tickers each week for you to exercise your skills, and judgment, getting ever closer to your own trading system.

    04-04-03 Pick Selection:

    Main Picks:
    AVII,AXCA,BE,BLDP,CAL,FAST,JOE,RBC,WORK,WSO
    Breakouts:
    ABCO,ADLR,AQNT,CPG,CYD,DOX,EELN,FLML,ILXO,SYNO
    QuickPicks:
    APCC,LGTO,LRCX,MDCO,NSCN,NWK,SCSS,SEBL,SU,WERN

    For detail and followup on Pro-fundity Tradescape,
    find the link on "Advanced Trading Tools" on the home page.

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    Take Action!