Determining Risk:Reward Ratios

November 23rd, 2012
in contributors

Online Trading Academy Article of the Week

It’s All In the Charts, If You Know What You’re Looking For

by Sam Seiden, Vice President Education, Online Trading Academy

What I always find fascinating are all of the different ways people look at charts and all of the different pieces of information people try to attain from a price chart. With so many different schools of thought on money, markets, charts, and so on, what should we really be looking for in a price chart? I mean, conventional technical analysis books have hundreds of pages in them with information on so many indicators, oscillators, chart patterns, and more. With all this, there must be some edge to be gathered, right? I speak with thousands of traders around the world and everyone is trying to make something “work.” This is where I see most people are off track. They spend more time trying to make the latest strategy or indicator “work” instead of taking a moment and “thinking” about how money is made and lost in the markets because after all, isn’t that what all the “work” is for?

Follow up:

Let’s go down the simple logic path for a moment and ask ourselves a few questions to make sure we are very focused on what information we need to get from a price chart.

Question: How is money made when trading a market?

Answer: Buy low and sell higher or sell high and buy lower.


Question: How do we buy low and sell high?

Answer: Figure out where price will turn and where it will go.


Question: How do we figure out where price will turn and where it will go?

Answer: Identify where willing demand exceeds willing supply.


Question: What does this look like on a price chart?

When we think in these simple terms, we see that the last question is all we need to focus on and the good news is, we have the answer. Beyond these questions, there is literally nothing else needed to consider when it comes to proper trading and investing, but most people don’t ever get to this level of simplicity because they are blinded by the illusion of complexity offered by the world of conventional technical and fundamental analysis. Let’s look at a recent trading opportunity from our Supply and Demand grid, a daily service for our Mastermind Community members where we deliver supply and demand levels in the major markets. I want to share a thought today that will help you increase your winning percentage and show you how to get this crucial, yet simple information from the price chart.

Click on graphic for larger, clearer image.

Increasing Your Winning Percentage

When we measure the distance from our entry price into a market to the stop loss price and compare that distance to our profit target, we get our “risk/reward” ratio. For example, “I am risking 2 points to make 6.” Of course the ultimate risk is the amount of money you are willing to lose and to determine what that number is, we always need to adjust position size depending on the distance from our entry to stop loss price. Wouldn’t it be nice to be able to look at a price chart and quickly see 3:1, 5:1, and so on? We can…

Notice the demand level of 1337 – 1341 on the supply/demand grid, the morning of November 16th. The demand zone is not shown on the chart, it was developed a few days earlier. This demand zone was a 4 point range which is also the distance from our entry to stop. That morning, price declined down to our level and gave our members an opportunity to buy. However, no matter how good the demand zone is, we must have a clear profit zone that offers us at least 12 points (3:1 reward to risk). Notice the first supply zone on the chart. This was the nearest area of supply above the demand zone that morning. It was 15 points above to be exact. So, the chart was telling us we could risk 4 points that morning to make 15. When the chart is telling us we can make 15 points and we only need 12 to make the risk/reward work, that makes this opportunity very high probability. Therein is my nugget of information for you…

If you’re looking for 3:1, make sure the chart is offering at least 4:1. If you’re looking for 5:1, make sure the chart is offering you at least 6:1, and so on… Make sure the chart is offering you more than what you are looking for and enjoy a higher winning percentage.

When the chart is offering 4:1 and you take your profit at 3:1, your odds of achieving your profit target are dramatically increased. You see, the chart gives you all the information you need, if you know what you’re looking for. You first however have to know what you’re looking for and then how to identify it on a price chart. Don’t let complex illusions created by conventional trading analysis distort what is really a simple picture of willing buyers and sellers. When it comes to “charting,” I’ll take my old color pencils and graph paper over the latest high tech charting package any day.

Hope this was helpful, have a great day.

Related Articles

Other Online Trading Academy Articles of the Week

About the Author

As the Vice President of Education at Online Trading Academy, Sam brings over 15 years experience of equities, forex, options and futures trading which began when he was on the floor of the Chicago Mercantile Exchange where he facilitated institutional orderflow. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated thousands of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.

Points of interest:

  • Chicago Mercantile Exchange Floor
  • Author of Market Advisory Letters
  • Fund Manager/CTA
  • Speaker to Investment Groups, Universities, and Private Seminars
  • Contributing Author for Stocks, Futures, and Options Magazine, Active Trader Magazine, and Futures Magazine
  • Trading and Investment Conference Speaker

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