In a previous article, we discussed the concept of building larger winning trades while keeping losers smaller. In addition, we highlighted specific psychological concepts, including the mental and emotional battles involved in trading. In today’s article, we will turn our attention to more of a system approach that gives you ways to consider the markets in terms of risking less to earn more.
Every trader is different. Therefore, I cannot craft a trading solution tailored to each of you. Instead, this publication is to stir your minds, enabling you to do the precise work of self-engagement. While these concepts may be simple, if you are trying to go to the next level, this presentation will give you plenty to consider.
First, let’s discuss the existing market opportunities and how they may factor into low risk and high reward possibilities.
I’ve observed among those in the retail trading world that scalping is a popular technique, especially for new traders. In my perspective, this is because many traders haven’t developed the patience to hold for longer durations.
While I believe in technical analysis, I still find that much of the market movement is random. This means that there is no significant underlying reason to expect the market to move in one direction or another, except for some occasions. Let me clarify; while there may be some technical reason to expect a move, chart analysis is not an exact science as many look at charts differently.
Furthermore, I’m not sure that the big money that moves markets is focused on what a micro charting timeframe suggests. In other words, if you are scalping, then you must do everything possible to enhance your edge.
With scalping timeframes, let’s say trades you expect to hold anywhere from a minute to ten minutes are very random. I find it challenging to have tighter stops and wider targets on these frames. If you are a scalper and struggle to keep your winners larger than your losers, you may need to widen your approach, give your trades more time, and use a different method. On the other hand, if you are scalping with low risk and high reward, then, by all means, carry on.
When a market breaks out of a confined pattern, it often provides traders with intrigue. It appears momentum and a new trend are developing. These ingredients would often present a good chance to enter with low risk and high reward, and this often works. However, breakouts are tricky. Many times there will be a breakout, but then the market will reverse and retest the breakout area. So, if you want to trade a breakout, there are a couple of important factors to consider.
One is the time of day. I expect that most of you are day traders and know the importance of timing. If a market experiences a breakout during a slow part of the day with less activity, I find it less appealing to jump in. However, if it is early in the day when momentum can carry the trend further, then it’s much more worth considering. Secondly, volume is also a tell. If a market is breaking out on good volume, then it’s worthwhile to pay much more attention to it. However, I’d generally prefer to wait for the retest if it is on low volume.
Naturally, one might expect that the more patient the trader is, the more precise and successful trade entries are, and this is true. Trading a retest is ideal if you want to keep losers small and winners large. This is especially true of a first retreat. Eventually, multiple retests will fail, but the first touch is often the safest.
Retests are best done when trading with the trend. So perhaps a breakout and then a retest of the breakout may offer an excellent opportunity. But there are other ways within a trend, let’s say a bullish trend, there is a pullback to some key level and then a continuation from that level.
I believe the best chance exists for small losers compared to larger winners in these cases. Additionally, I think your probabilities are better. What you will have is the best of many worlds. On the larger time frame, you are still trading with the broader trend; however, you are setting up for a reversal on the smaller time frame. Catching a reversal typically offers the best chance for a large winner, and when done in conjunction with the dominant trend, it presents significant opportunities.
Finally, in this section, I want to address the idea of reversals as a stand-alone. I presume that this method is widely popular. Simply put, calling market highs and lows, tops or bottoms, catching a falling knife, or trying to stop a launching rocket can be risky. This is why it should be done in parallel to a larger trend.
What I’m about to say is especially true when you don’t have any trend in your favor, but you are trying to catch reversals. The chances are, you will have more losing trades than you will winners. Some days you can do alright, but on “trend days,” you’ll be fighting all day and exhaust yourself and your money.
I only advocate trading reversals when you are on the side of a larger trend. If you insist on trading against the proverbial grain and try to catch trend chances and go against momentum, you must use much larger targets than stops. In many scenarios, a 2:1 or 3:1 return on risk is necessary, but if you are trying to catch every falling knife, I suggest at least a 5:1 return on risk. Otherwise, I believe you are risking your longevity.
In this section, we want to move away from market opportunities to examine some trading methods with larger winners and lower risks.
Keep Your Risk-to-Reward Profile Fluid
Once traders learn the necessity of utilizing a healthy ratio in terms of return on risk, one of their mistakes is becoming too rigid. One of the unheralded ways to take your trading to the next level is by assessing each trade as to its potential. Some opportunities feature a 2:1 return on risk; other setups will merit a 5:1 type of chance. The key is to be fluid, allowing your market to dictate this. For example, during volatile times, a 5:1 can work, but in slow periods, 2:1 may be much better.
Where To Set Targets
One way to set your targets is at previous levels. For instance, if you are buying, set a target at previous resistance. You may want to scale out halfway there and then more at the resistance level and hold a runner position if resistance breaks. You can look at a chart and tell where momentum frequently ceases, and markets begin to slow down and potentially reverse. Then, based on where your target is, you’ll know how to manage your stop to ensure a proper risk-to-reward ratio.
Another way to set targets is by using standard deviations. I like to plot 20-period moving average Bollinger Bands on my chart, with 1, 2, and 3 standard deviations. If I buy at -1 standard deviation, as an example, then I’ll likely target +1 for my first scale, +2 for another scale, and +3 for an additional scale.
Simply noted, you can plan a responsible stop when you know your target(s).
Where To Set Stops
There are some instances in which your target is less clear. In that case, and in some other scenarios, it may be appropriate to set your stop and then determine how wide your target should be. As an example, let’s say you assess a good stop based on your chart is to risk $200; then you’ll know that this trade should at least target $400 worth of profit.
I often let the charts inform me of where to set my stop. There are also good technical indicators on most charting platforms that provide a helpful detection for stops. For example, let’s say I’m long; it may occur when a market breaks some short-term support. Other factors could include volatility. In a volatile market, if I’m long and a market breaks the previous bar’s low after I enter, I’ll exit. However, I would exercise more flexibility in slower markets, most likely a money stop. In other words, I’ll risk x amount.
This article has examined some practical ways to consider how your trading may incorporate wider targets compared to tighter stops, giving yourself big winners and small losers. These reflections should merely be conversation starters, enabling you to discover what works best according to your trading personality.