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Understanding Risk & Reward

July 5, 2012

One of the challenges that face all day-traders is a tension between the need to trade with frequency, and the importance of waiting for great opportunities. What defines a great opportunity? Everything else being equal, I want my potential profit or reward to be substantially greater than my risk (the distance from my entry to my stop-loss).

My first entry today was on the pullback after the open. I prefer to enter around diagonal support or resistance, as these areas are where I can anticipate buying renewed buying and selling interest in line with the longer term trend. Sometimes I’ll forsake this, and enter around the EMA. I did this here for two reasons. The first was that the CCI wasn’t overbought when price hit the trend-line, but the main reason was that the risk:reward ratio simply wasn’t good enough. From the trend line to the last swing low would have given me a profit target only a little larger than my stop-loss. At the EMA I had a full twelve ticks of potential profit – a much better ratio of reward to risk.

My next entry was also short, on another pullback. Which trend-line to use this time? It didn’t really matter, as the market headed higher and I would have been stopped wherever I entered. Nevertheless, my loss was much smaller than my potential profit on a retests of the lows.

The change of trend wasn’t difficult to spot, and I began looking for long entries. This time the EMA didn’t offer a very good risk:reward ratio, and there was no diagonal trend-line to enter against. I’ve highlighted this area on the chart. I entered at the EMA, which in hindsight was fairly ill-advised, although the trade eventually worked out. Notice the failed attempt to make a new high after my entry, but also that the new low that followed showed divergence with the CCI.

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Daytrading Chart 5th July

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The final entry of the day produced a loss. Here the EMA and trend line provided support and the CCI was oversold, but we didn’t retest the highs.

So I showed a small profit on the day, despite only a 50% win rate. Simply put, that’s because my wins were greater than my losses. This is how an understanding of risk:reward ratios and having the patience to wait for good opportunities can help.

View Today’s Complete Chart

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