How to Determine Risk/Reward Ratio on Your Trades (Part 1)

07/20/2009 10:32 am EST


Timothy Morge


I made a nice gold futures trade this past week in my live pre-market session. It's an interesting trade to review because it combines several techniques and also caused quite a stir in the live session when I introduced the concept of dynamic risk/reward ratios to the group.

Let's take a look at the gold futures charts as I marked them up during the first morning session:

Click to Enlarge

As you look at this chart of gold futures, your eyes should notice two things: 1) Price is cascading lower in a strong trend and each cascade is lower; and 2) None of the swing highs that make up each of the “cascades,” or “wavelets” against the trend were able to break above the top of a previous cascade's swing high. By analyzing the quality of this downtrend and seeing price's pattern repeating over and over, we are able to watch for any signs that a change in trend may be occurring and our first cue will generally be a change in these repeating patterns.

Let me show you what I mean:

Click to Enlarge

Price suddenly spikes higher, breaking above two prior swing highs and well above the top of the prior cascade’s pullback. This is a major change in behavior and a sign that though it may not yet be time to enter a long position, it is time to watch for further signs of strength.

If price just made an important change in behavior, what would the probable path of price be?

Click to Enlarge

I use the major low at 'A', the major high at 'B,' and the major low at 'C' to produce a Median Line and its parallels. The Median Line will project the probable path of price forward into time and space and the upper and lower parallels will show me the likely distance price will oscillate around the probable path of price.

This is quite a large Median Line, and because the distance is so great between the Median Line and its parallels, I'll need to use a finer tool to help me identify a high-probability trade entry set up that I am willing to trade.

More tomorrow in Part 2. Read Part 2 | Read Part 3 | Read Part 4 | Read Part 5

Timothy Morge

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