The visitors to this trading blog are great. I enjoy questions that deserve a full response and this one is no different.
Before we start I want to point out that many things we’ve all been conditioned to in regards to trading, are not accurate. It reminds me of a baseball swing. Over the years, as more statistics and technology has become available, we have found that usual teachings are flawed.
Squish the bug
Knob to the ball
Lead with the hands
When looking at elite players, we see that they don’t really do that. Slow-mo video and 3d models derived from muscle impulses shows what constitutes an elite swing.
In trading, there’s a lot of “rules of thumb” that over a large set of trades, just don’t pan out.
Anyhow, here is the question…..
Hi Sd, thanks once again for a wonderful and very informative blog. Here is my question: when a possible trade has lined up and then you see that the risk to reward is less than 1R do you still take the trade?
That is a great question although the answer would not be a simple yes/no.
First let me say that a reward risk ratio is meaningless without an edge and only important over a large set of trades.
The common thing you hear is “never take less than a 3:1 reward risk ratio.” That is followed by “I can be wrong 3 times and still make money.”
That’s flawed when you factor in position sizing and percent of account.
The other flaw is thinking that going after a larger reward risk ratio will actually lead to success. That would assume that the market is a fair beast following the logic of the “path of least resistance.” It isn’t.
Is the market more likely to move in one direction?
This is where I lay my concern. Yes, there are clues on your trading chart where the probability is.
Is there room for price to run in that direction without hitting support or resistance (by what measure are you finding these levels anyhow??). If I am trading a daily chart and there is upside room…what if the 4 hour chart has a resistance level?
Will that not affect my R:R?
There are many stats that I’ve done (and seen) over the years that show having a larger R:R has little effect on overall success. We can’t ignore solid quantitative evidence over theory.
We also can’t expect, regardless of market structure, that we will be given our 3R profit just because we want it. Thinking 3:1 (or any ratio) will happen consistently to give it any meaning is fantasy.
So, in answer to your question…it depends….but I don’t focus on the ratio…I focus on probability. I focus on the expectancy of my edge.
Expectancy = Net of all trades / Total number of trades or (Win rate x Average win) – (Loss rate x average loss)
Looking at a pullback trade….if price has extended far from the mean, I expect a retrace over a continuation. Now, the retrace can be one day (you can see it in the candlestick with the presence of upper lower shadows) or several days but buying the high is a risk when looking at extended trades. I won’t enter a trade that has setup, triggered in and moved a distance from the point of interest.
I enter trades using a stop loss that is derived from ATR. I manage trades looking for adverse price action. I take partial profits at 1R.