How to Determine Risk/Reward Ratio on Your Trades (Part 5)

07/24/2009 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

Some traders and analysts feel that trailing stops are folly. In fact, one recently wrote in a national trading magazine: “Because the big scores are so hard to catch, anyone using any form of trailing stops doesn't understand risk reward analysis.” Let's see if we can make the case for using some form of trailing stops:

chart
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If you are long at 907.80 and price manages to climb to 930.80, if I don't move my initial stop loss order, price will fall $25 before stopping me out of my position. And even if I am using the most optimistic profit target on this chart, I'll be looking for price to climb an additional $9 to reach my profit target. That means that at the beginning of the trade, my risk/reward was 16 to 1. But what is my risk reward ratio now? Is it infinite, because my position is very profitable? That would only be the case if I moved my stop loss to a stop profit, and even then, I believe we always need to consider opportunity costs.

If you literally will not move your stop loss order above 905.80 and you will not move your profit target from 939.80, you are risking a fall from the current price of 930.80 to the stop loss at 905.80 ($245) to make $9. That makes your risk/reward ratio 0.36 to 1, which is...well… awful! The risk/reward ratio has been completely tipped on its head.

If we currently have $25 in potential profits in this position, can the risk reward ratio really be that bad?

Let me suggest a middle ground in logic and trading practice:

chart
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If you look at this chart, you'll see how this trade played out for me. I risked an initial $2 per contract and made $33 per contract. Did you pick the right profit target? (I have a secret for you: You could have picked any of the four I mentioned and done just fine, because you were risking $2 to make at least $7 in each case, and that means that at minimum, your risk reward ratio was 3.5 to 1.) All four profit targets were acceptable and all four were met.

The difference between the four was time spent in the trade, and at times, you should have been able to hide profit stops under swing lows that formed as price climbed higher. Instead of using cash stops, I always hide my stops and profit stops beyond swing highs and lows, because there are generally a great deal of resting limit entry orders at those levels. And you can see that I boxed in my profits by hiding my stop profit orders under each new swing low as price continued higher. Had price backed up unexpectedly, I didn't have $25 in potential profits left on the table—I was quickly working profit orders to ensure I would book at least some profits after price had climbed a minimal amount.

I hope you found this discussion about entries, profit orders, dynamic risk/reward ratios, and stop profit techniques interesting. Trading is both an art and a science, so there is room for many styles as long as they are profitable in the long run!

I wish you all good trading! Read Part 1 | Read Part 2 | Read Part 3 | Read Part 4

Timothy Morge

timmorge@gmail.com
www.medianline.com
www.marketgeometry.com
Twitter: @TimothyMorge

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