Risk to Reward ratio.

The issue of a trade’s value from a consideration of Risk to Reward came up during the week as I was starting my TC Trial. This article highlights the issues that are important to consider when evaluating Risk to Reward in consideration of TC signals that trigger within Technical patterns and those that trigger with a break of technical pattern.

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 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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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, wait for a TC signal that triggers once the trend line has been broken.

TC Signal with breakouts from Technical Patterns:

Friday 26th May 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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Summary: 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.

Final word: The best outcomes from trading TC signals are generally seen when the 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.