By Rob Colville on December 16, 2016 in
If you’re a visual learner like me, you’ll very likely agree that there’s no better way to learn about a trading concept—like reward/risk profile, for example—than to see it right there before you. That’s why I’ve compiled some recent examples of various trading opportunities, some with good reward/risk profile, and some without, so we can examine the characteristics of each more closely.
Now, call it a New Years’ Resolution of sorts, but I hope to do this a bit more often, providing actual market examples that help illustrate how and why we take certain trades, as well as why we opt to pass on others. So here are real trading case studies showing what favourable (and unfavourable) reward/risk profile look like on the charts, and how it’s played into our recent trade decisions. Oh, and don’t look now, but if you read on, you just might find a potential set-up on the way that could present the most appealing reward/risk profile of any set-up seen in quite a while!
The bearish pin bar reversal seen recently in CADCHF made for a rather compelling short entry signal for a variety of reasons: 1) It occurred just below strong resistance in the form of a range boundary in place for more than a year now; 2) This resistance level has twice been tested and respected; and 3) Seasonality over the last 20 years (not shown) favours Swiss franc (CHF) strength.
However, even with numerous factors lining up in favour of selling CADCHF at this key resistance, it’s the outstanding reward/risk profile that ultimately made this set-up one worth taking, and we’ve zoomed out a bit on the below chart to better illustrate that fact:
As shown, with CADCHF having traded in this range for nearly a year and a half, and with price now so close to the upper range boundary, probabilities are strongly in favour of the pair reversing lower at this juncture, perhaps even targeting the lower range boundary.
With that, a small risk approximately the size of the bearish pin bar itself could yield a gain ten or more times that size in the event that a downward move does once again materialise from this level.
Clearly, the analysis, coupled with the outstanding reward/risk profile of this set-up, and the clear entry signal in the form of a bearish pin bar reversal, combine to make this a tradeable set-up. And, with very large profit potential compared to the nominal risk involved, it seems that this short opportunity in CADCHF is well worth the risk.
Not every set-up for which technical analysis goes in favour, however, is a tradeable one, as we see on the below chart of USDSEK. This pair has gotten some attention recently, with the upward trajectory of the US dollar (USD) driving the pair decidedly higher. The strong order, angle, and separation of the 20-, 50-, and 200-day moving averages on the chart confirms the upward momentum.
Price action traders started paying even closer attention to USDSEK following the emergence of a bullish pin bar reversal, which occurred at the tail end of the recent pullback. And while those factors all suggest buying the pair, a closer look at the reward/risk profile is all that’s needed to invalidate this potential long trade.
Notice on the above chart, if you will, that the area between the potential entry point and stop loss is roughly equivalent to the size of the bullish pin bar reversal. Considering that the potential price target would only be the recent swing high, a reward/risk profile of barely 1:1, if that, is present here, which makes the risk one that’s simply not worth taking, as our strategy requires at least 1.5:1, and preferably 2:1 or higher in order to justify putting our hard-earned capital at risk in any market.
See related: Pin Bar Mistakes That Are 100% Preventable
So the lesson here is simple, yet crucial: No matter the technical and/or fundamental factors going in favour of a particular trade, if the reward/risk profile doesn’t fit the requirements set forth by your strategy, then by rule, you must pass on the trade.
Whenever a given set-up is invalidated, whether it’s due to sub-standard reward/risk profile or another factor(s), you mustn’t be fearful about moving on, and in part, here’s why: Because another, even better opportunity could be presented in short order.
With the holidays upcoming, many traders are on the lookout for the seasonal cycle known as the “Santa Claus Rally,” which tends to drive equity indices like the FTSE 100 (chart shown below) and S&P 500 (not shown) higher through December and into early-January. The problem this year, however, is that both indices are trading at or very close to all-time highs, which is why we’re looking to sell the FTSE near the 7100 level instead.
As you can see, doing so could create a trade with truly outstanding reward/risk profile, as a short trade taken right near the all-time high could be taken with tight risk, yet yield a sizable downward move. And if triggered into the trade by, say, a bearish pin bar reversal, price could subsequently target the recent swing lows or even surpass them, and would encounter little technical support for quite some way below those levels.
This potential reversal opportunity in the FTSE is low-probability, by nature, but with exemplary reward/risk profile and a reasonable technical justification for taking the trade, it’s one that’s worth watching throughout the days and weeks ahead.
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