From the March 01, 2011 issue of Futures Magazine • Subscribe!

The trader's equation: Should I take this trade?

Directional edge

If the market is in a strong bull trend, such as in "Power up" (below), 80% of reversal attempts will fail. That means that about 80% of the pullbacks will result in a test of the high of the trend.

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If a trader bought a small two-legged pullback to the moving average and there was a bull signal bar, it is reasonable to assume that there would be a 60% chance of making two points before losing two points. Also, if the trend began with a strong bull spike composed of two or more consecutive bull trend bars with large bodies and small tails, the chance of making two points on a long before losing two points is probably at least 60%. If the trend is strong enough, and the trader swings the trade, he might discover that his average win is five points while risking just two points and his winning percentage might be greater than 60%.

If the trader took this setup 10 times and won two points on his six winners, he would make 12 points while losing a total of eight points on his four losers, for an average profit of 0.4 points per trade. The reality is that the probability is likely 70% or more in a strong trend, the risk is often six or seven ticks instead of eight, and the reward is often four or more points, so the setup is even stronger. With a 70% chance of making four points before losing two points, the average profit per trade is 2.2 points, or more than $100, which is great for a day trade.

When the market is in a trading range, it spends most of its time in the middle where the directional probability of an equidistant move is 50% (see "Middle man"). The middle of the trading range is where uncertainty is greatest, and that means the probability of the market going up one point before dropping one point is about 50%.

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