A trader always should know his risk and have a good idea of his potential reward when entering a trade. His risk is the number of ticks from his entry price to his protective stop. His reward is the number of ticks from his entry price to his profit target. Most traders always should have a risk that is at least as large as the reward, otherwise they have to win on 70% or more of their trades to be profitable. That is an unrealistic goal for most successful traders, and a delusion for anyone starting out.
If a trader uses a reward equal to his risk — let’s say two points for both — then he has to be right at least 60% of the time to begin to make a profit. That still is difficult to do, but possible with experience. If his reward is two or more times greater than his risk, then he can be right just 40% to 50% of the time and be profitable. Because of the math, most traders should start out looking for trades where the reward is at least twice as large as the risk. This consideration affects how we approach our analysis of the prior price bar.
When a bar is forming and it has not yet gone above or below the prior bar, a trader needs to consider whether it is likely that there will be an imbalance between buyers or sellers on a breakout above or below that prior bar. Next, he has to decide whether the breakout will go far enough to make a reward that is at least as big as the risk.
For example, if a trader is buying a two-legged pullback to the moving average in a bull trend, and the market forms a strong bull reversal bar at the moving average, buying at one tick above the high of that bar, risking to one tick below the low of that bar, is likely to result in a move up at least as great as the number of ticks at risk. This means that this is a mathematically sound long (the trader’s equation is positive, which means that the probability of success times the reward is significantly greater than the probability of failure times the risk). In general, for a move above or below most bars, the trader’s equation is not positive enough to take a trade or a trader cannot confidently make the assessment. However, with experience, a trader might see about 20 to 30 potential trades a day on the five-minute chart, and he might feel confident enough to take five to 15 of them.
There are, of course, variables that a trader has to consider when deciding the probability of a successful trade. The most important is the overall context. If the market is in a strong bull trend, only look to buy and assume that every sell signal will fail and evolve into a bull flag. In a bear trend, look for shorting opportunities. In a trading range, look to buy low, sell high, and scalp, realizing that the market will create strong rallies that repeatedly lead to reversals down and strong sell offs that soon will reverse up. As strong as the rallies and sell offs often are, don’t get tricked into trading in the wrong direction, because 80% of the breakout attempts will fail and lead to reversals.
Traders have to assess the strength of the signal bar, especially in relation to the past several bars. If a sell signal bar has a one-tick bear body and it follows four big bull trend bars with big bodies, the signal is weak and there might be more institutional dollars looking to buy at and below the low of that sell signal bar than there are dollars looking to sell. In that case, it makes more sense to place a limit order to buy at or below the low of that sell signal bar than it does to go short there.
Support and resistance also are important. If a trader is looking to buy and the bull signal bar is reversing up from a bull trendline, the chance of a profitable trade is greater. The more signs of strength of a breakout are present, the better it is to look to enter on a stop in the direction of the breakout.