Hello traders! This week I would like to take a look at the possibility that you missed a terrific entry on a trade, but you are still confident in the eventual destination. How far are you willing to “chase” the trade? Looking at the following chart, we have several possible entries for a short EURUSD trade. The first red arrow labeled “1″ would have been the best entry as we have a trendline break and a re-test of a supply zone in the 1.4673 range. We also have a very healthy profit target near the 1.4328 range, giving us a reward:risk ratio of about 10:1 (~345 pip target with ~30 pip stop.)
While it is easy to see a 10:1 reward to risk ratio when looking at a chart from the past, looking at a chart live is a different beast altogether! It is realistic to assume you may have had much smaller profit targets while watching the live charts. As we can see, these minor demand zones (marked with the cross-hatched yellow zones) were only speed bumps along the way to our eventual 1.4328 range. So let’s assume you analyzed the chart and believed that eventually we would see this bottom target – how many more chances would you have had to enter a short trade?
The general Online Trading Academy reward to risk rule is to only take trades that offer you a potential 3:1 ratio. This second chart is merely a close up of the previous chart, with a couple of trend following trade entries indicated. The red arrow marked “2″ would have been a potential short trade using a trendline trading technique – this would have been the third or maybe fourth touch of the trendline to prove its validity. While not indicated on this chart, the high of that candle also was re-testing another supply zone, PLUS it was giving us a possible right shoulder on our head and shoulders reversal pattern. The head and shoulders pattern is easier to see on the first chart. So what was the reward to risk ratio here? Selling at the 1.4650 level with the same 1.4328 target would have given us a reward of ~325 pips and a risk of ~50 pips for approximately a 6:1 ratio. Still pretty good!
At the red arrow labeled “3,” there was a Fibonacci retracement of ~38% which gave us another entry on the short side. (My basic rules on Fibonacci are these: 1. Larger time frames are possible supply and demand zones. 2. Smaller time frames are good for trend following trades. There are dozens of Fibonacci techniques, but that is how I use them. To hear all of my Fibonacci rules, see you in class!) So selling at ~1.4543 Fib level still gives us a reward down to the 1.4328 target, but where does the stop go? Way up above the 1.4697? That works out to be 220 pip reward and a 150 pip stop. Not quite what I had in mind! So now it begs the question where should my stop go for my minimum 3:1 reward to risk ratio? In this example, my stop would go above the cross-hatched yellow demand/supply zone, at approximately 1.4580, which then improves my risk to only 45 pips or so. 220 reward and a 45 risk, 5:1, works for me!
Last but not least is the arrow marked “4.” For clarity on the chart, I did not mark the trendline that exists from the #2 arrow that intersects this entry (third touch again!), nor did I mark that this is another Fibonacci trend trade. Go back on your charts and mark them; they are there! If you use neither of those trend following techniques, this is also a classic example of a breakdown and retest of the 1.4474 level. So again, is this a quality trade that we can take, using the 1.4328 as our target? The reward works out to be ~150 pips, but what is our risk? Obviously, again, our stop can’t be above the 1.4697 level. Placing our stop above the previous swing high (red arrow marked 3) gives a stop of ~75 pips. Many short-term / intraday traders will take a 2:1 reward to risk ratio, so this would be acceptable to them. Built into this 60 minute chart is a smaller, less obvious swing high at approximately 1.4500. This would give a stop of ~30 pips for a ratio of 5:1.
So what is the big takeaway from all of this? Properly identified major supply and demand zones will give the best reward to risk ratio trades, obviously! The only problem is the proper identification of them. At the time, we aren’t sure how far this trade will run. By identifying the major vs. minor supply and demand zones, we can join the trend by entering near the minor zones, taking us to the major zones. Make sure your stop is adjusted to what is potentially “left” in the trade to keep your ratio in line with proper risk management!
Keep reading all of the Lessons from the Pros newsletters and the proper identification of these zones will get easier with practice!
Until next time,
Rick Wright firstname.lastname@example.org