Risk to Reward ratio.

The issue of a trade’s value from a consideration of Risk to Reward came up during my TC Trial. This article addresses the important factors to note when evaluating Risk to Reward in consideration of TC signals that trigger:

    • with a trend line breakout from a Technical pattern.
    • within Technical patterns. This includes those TC signals that trigger with a bounce back down within a technical pattern and for those that trigger in the face of a trend line from a technical pattern.

TC Signal with breakouts from Technical Patterns:

Friday 26th May 2017 ended up being a day of Yen strength and much movement across Yen pairs and this example uses the move on the EUR/JPY. My morning update on that Friday revealed the EUR/JPY setting up with the following consolidation pattern on the 4hr chart (see below). Traders need to look either side of such consolidation patterns and check to see whether there are any major horizontal support / resistance levels or key Fibonacci zones that could impact price action. This 4hr EUR/JPY chart revealed that any breakout to the downside had a reasonable amount of room to move with the first Fibonacci level being almost 200 pips away:

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This was how the 15 minute chart of the EUR/JPY was setting up around the time of update:

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A new TC SHORT signal ended up triggering along with a trend line breakout during the Asian session on Friday 26th May. The Stop required for this trade was 30 pips and, given the scope for potential lower movement, this offered up a reasonable Reward for the amount of Risk taken. Price action for this SHORT move slowed once it reached 100 pips but this still offered up to a 3:1 Reward to Risk opportunity.

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Setting profit targets on breakout trend trades can sometime be problematic but important consideration needs to be given to at least two issues:

      1. The size of the Stop required.
      2. The amount of room until the next major level of potential Support or Resistance.

Again, a 2:1 Reward to Risk ratio or higher would be preferred for such trades.

TC Signal within Technical Patterns:

Support / Resistance: Traders need to be aware of potential Support and Resistance levels for any instrument they are trading.  The recent example for one participant in the TC Trial was with the GBP/CAD and this is how I saw the 4hr chart for this pair setting up at the time of the trade. There was a clear descending wedge in play with a support trend line under price action that had been in force for around three weeks:

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Stepping down to the 15 minute chart rendered this view:GCB15

Insufficient Reward to Risk potential: The TC signal in question is noted in the chart below. Apart from the fact that Thursday May 25th 2017 was OPEC Meeting day and, thus, I would not have traded CAD pairs this trade also came with other risks. The TC signal triggered close to a support trend line and so there was potential that price could have just as likely bounced back from there. With a Stop placed on the other side of the Cloud giving a risk of about 20 pips, this trade did not offer a worthwhile Risk: Reward ratio.

In this type of situation, when a TC signal triggers close to a support trend line, my suggestion is to wait to see if price action breaks and closes on the other side of the trend line to render more confidence in the trade outcome. In this case, price did indeed bounce back up from the support trend line and so the TC signal failed.
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Sufficient Reward to Risk potential: There was a TC SHORT signal on this pair from the day prior though where the Risk: Reward was much more favorable. In this case the Risk was about 30 pips with the Stop placed on the other side of the Cloud. However, note how with this set up there was about 130 pips worth of room to the downside before the support trend line.

This trade offered a Risk of 20 pips for a potential move up to 130 pips. Thus, a 30:130 ration or about 1:4. This TC signal, despite not rendering with a break of trend line, would have offered a reasonable opportunity based on the favorable Risk to Reward potential. This TC SHORT signal would have been a very profitable one indeed!

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New TC signals in the face of trend line:  The example of the GBP/CAD pair above illustrated the problem of blindly taking any new TC signal in the face of an S/R trend line. This particular example was more problematic due to the large Stop that was required for this trade. There are some situations though where new TC signals trigger in the face of an S/R trend line and where the risk is rather small. Under such circumstances these trade may be worth considering.

The example below shows two 15 min chart TC signals that triggered on consecutive days on the USD/JPY during August 2017. The first TC signal came as price was bouncing off a support trend line and needed only a small Stop of 10 pips. This trade gave a 6R trade result (that is, the Reward was 6 times the amount of Risk.

The second TC signal though triggered in the face of a resistance trend line and, thus, may have been preferentially ignored for this reason. However, given the Risk here was relatively small at 20 pips then some TC traders might be happy to take on that Risk. The other option available too is to wait and see if there is any continuation move and trend line breakout to take the trade as mere trend line breakout move. The key factor here is to consider the Risk of the trade prior to ANY decision to take the trade:

Summary: When considering taking any TC signal that triggers within a technical pattern give consideration to the potential Reward to the amount of Risk required. A ratio of over 2: 1, that is, where the Reward is at least two times the Risk would be a decent guideline here. Otherwise, it is preferable to wait for a TC signal that triggers along with trend line breakout. 

Exception to this above rule: the only time a trader should consider options for taking a TC signal in the face of an S/R trend line would be if the relative Risk was small and the trader was comfortable with that risk and the potential that the trade may not work. Alternatively, waiting for a trend line breakout to take this move as a simple tend line breakout trade is an option too.

Summary: The best outcomes from trading TC signals are generally seen when the TC signals trigger along with a trend line breakout, however, TC signals taken within consolidation patterns can be profitable as well. Irrespective of whether the TC signal evolves with or without a trend line breakout, traders MUST consider other potential road blocks for the trade and evaluate the Risk : Reward ratio before taking any trade. 

Final word: I would always urge a trader to wait for TC signals that:

  • Trigger with a break of a 4hr chart trend line. This set up generally offers the highest probability trade outcome for the TC Trading system and is the set up given most value and priority. Preference is always given to New Optimal TC signals though as this is the ideal set up for the TC Trading System.
  • Trigger after a bounce off a 4hr TL BUT the potential Risk /Reward is very good (2 R or more) and the Stop size is small (20 pips or so or less).
  • Trigger near or in the face of a 4hr TL BUT the Risk /Reward is good. That is, the Risk is very small (20 pips or so or less) and the trader is aware that the signal could fail once price hits the looming trend line.

NB: I see Stop size here as a reflection of volatility. However, I am aware that traders load trades of different Stop size to fit their risk profile but a note of where the TC signal triggers with respect to the Cloud is critical here.