The Tried, True and Tested Over Time Technique for Minimizing Risk While Maximizing Reward
By Dr. Barry Burns, TopDogTrading.com
There are 2 ratios that dominate professional traders’ thinking:
- The win/loss ratio of their trades.
- The risk/reward ratio of their trades.
Notice that I intentionally worded each bullet point above with the words “of their trades.” It may seem practical and objective to back test a trading system to determine these ratios, but what’s more realistic is to trade a method yourself over a significant, statistically significant number of trades, record your actual real-world results, and use these numbers as your own win/loss and risk/reward ratios.
I know traders who play one game or the other.
In other words, it’s not unusual for scalpers to have a very favorable win/loss ratio, but a risk/reward ratio of less than 1:1. p
On the other side of the continuum, there are trend traders who have an excellent risk/reward ratio (making 3-5 times or more what they risk on their winning trades), but they have more losing trades than winning trades.
Both types of traders can be profitable as long as they know their numbers and keep the combined ratios in check so that they maintain the net results of their P&L in the green.
In my own trading, I use both styles. I have various trade setups that have different expectancies. Some of my trade setups are designed to catch short-term high probability wins that put money in my pocket consistently. Other trade setups are designed to participate in long-term trends.
I like having tactics for both styles of trading because it allows me to trade under varying market conditions. You can only make as much money as the market provides (based on its range), and markets only trend approximately 20% of the time. Therefore I have a quiver full of trade setups designed for various types of market conditions.
This article is focused on trading for a high reward, while risking a small amount of money. Therefore I’ll focus on trend trading and its counter-part, trend reversal trading.
Being the author of the book, “Trend Trading FOR Dummies” (Wiley), I’m quite familiar with trading trends and it’s at the core of my trading style. The first step in my chart analysis is always to determine whether or not there is a trend.
Before we go any further, it’s critical to define the term “trend.” According to Webster’s Dictionary, the word “trend” means “to extend in a general direction.”
In that definition, the words “extend” and “general” clearly indicate that a trend refers to a long-term move. The fact that trading with the trend is designed to catch long-term moves therefore makes trend trading an ideal trading approach for cashing in on big financial rewards while risking a relatively small amount of money.
As mentioned above, markets don’t always trend. They don’t always follow through in long term direction up or down. Sometimes they consolidate and meander sideways for a period of time.
This begs that question, how do we determine when a market is trending? What objective method, tool, or measurement can we use to indicate that the market is making a long term directional move up or down?
Hindsight is 20/20 of course. Analyzing historical charts is always easier than actively trading the hard right edge of the screen where the future is unknown and therefore any trade we take will always have an element of risk.
To keep our risk small (half of the low risk / high reward equation) I use protective stops and hedge my positions with the use of options strategies.
But what about the “high reward” half of the equation? We need an objective measurement of when a trend is likely to begin.
There are many ways to do that. Some traders define a bullish trend as simply higher highs and higher lows, although such a price pattern can be a short-term move.
There are a plethora of sophisticated mathematical calculations converted into indicators that can be used. I’d be dismissive if I said there was one “best” way to determine a trend.
Personally, I’ve tried many different approaches over my decades of trading, and like most things in my career, I’ve returned to the simple basics.
The two most commonly used moving averages, used by traders and investors I have known over the years, have been the 50 period simple moving average and the 200 simple moving average. I consider these to be the two most important moving averages.
Don’t attribute any type of “magic” or mystical numerology to them. They’re effective for the very practical reason that they are used by such a large number of market participants and as a result have a self-fulfilling prophetic nature to them.
Because such a large portion of the trading community watch these two moving averages, when the price of a market comes into those levels, people buy or sell off of them, or take profits into them.
They serve the dual purpose of support/resistance and trend indicators.
I consider the 50 SMA (simple moving average) to be the intermediate-term trend and the 200 SMA to be the long-term trend.
At this point in the discussion I normally receive questions asking why I don’t use exponential moving averages, or shorter-term moving averages, because “they follow price more closely.”
That’s exactly why I DON’T use them. I don’t want a moving average, or any indicator, that follows price. That’s useless since I can see what the price action is doing. I want something that shows me something DIFFERENT from what the price bars are doing. Looking for the indicators doing something different than the price action is actually what gives us high-probability setups!
Depending on your trading preference, you can trade trends based on the intermediate-term trend (the 50 SMA) or the long-term trend (the 200 SMA).
Trading the intermediate-term trend will provide you with more setups, but lower rewards simply because it gets you into shorter-term trends.
Trading the long-term trend will provide you with fewer setups, but higher rewards because you’ll be getting into longer-term trends.
If you have an agile mind and can handle both perspectives, you can trade both!
In this article I’ll focus on the 200 SMA.
In the above chart of the S&P 500, the 200 SMA is the purple line angling up.
One of the keys to successful trend trading is to enter EARLY in a NEW trend.
A very popular saying in trading is:
“The trend is your friend until the end.”
Then there’s the follow-up joke:
“How do you know when the trend is going to end?”
“Right after you get in!”
I know it feels like that sometimes, but the saying is instructing us in a very important lesson. Trends are long-term moves, but they don’t last forever. In order to get the best risk/reward ratio, it’s critical to enter as early in a new trend as you can. That leaves you plenty of time to participate in the majority of the move and enjoy maximum profits.
One potential optimal time to enter a new trend, using the 200 SMA is when price crosses it from one side to another.
In the chart below you see an example of the EURUSD crossing from above the 200 SMA to below the 200 SMA to begin a new downtrend.
Entering the market short after the cross of the 200 SMA would have provided you with an excellent reward because you’re trading in the direction of the long-term trend and you’re entering that trend early.
Notice in the chart above, the market crosses below the 200 SMA and then comes back to test it as resistance before continuing down. This is a frequent occurrence and an excellent opportunity for a trade entry.
Notice the same retest of the 200 SMA in the chart below, this time in an uptrend.
We’ve seen examples with the S&P 500 daily chart and the spot Forex EURUSD daily chart, but this approach also works for intraday charts for those who like day trading, and it can create some huge winners … IF you do it right.
Here’s an example of how to do it wrong on the e-minis 1,000 tick chart:
QUIZ: Can you tell what’s wrong with that trade entry?
The market is below the 200 SMA and the 200 SMA is going down, so we’re in a downtrend, right?
The problem is the timing. Remember the basic trading rule: Enter a trend EARLY in a new trend. This entry is too late to the party. All trends come to an end, and the longer the trend continues, the less likely it is to sustain.
Here’s what happened after that …
Luckily the market did go down a little after that entry (the market won’t always be so kind), but comparing with the chart above this one, you can see how little of the potential reward you were able to get out of a long bearish move if you would have entered when the price bars initially crossed the 200 SMA.
Extended trends are very risky. There isn’t a high probability that the market will continue trending, thus lowering your win/loss ratio. But there is a certainty that you won’t get as good a risk/reward ratio.
Now if you waited for the next time the price bars moved above the 200 SMA (as shown by the arrow on the above chart), let’s see what type of reward was available to you in the chart below:
Most importantly, not only was it a better risk/reward trade but it was a safer, more conservative trade. Also notice how the price bars responded to the 200 SMA when it first approached it from below. Price bounces off of it twice as resistance before breaking through above it. This is because a large number of market participants are watching, and responding to, that 200 SMA.
Trend trading is one of the most tried and true, tested over time techniques for making money in the markets. It’s an especially good method for making low risk / high reward trades.
But it must be done with care and skill. Entering a new trend early is key and staying in the trend for the full move is critical for making the most of the reward offered by a long-term move in the market.
To continue this lesson, you’re invited to watch a free video that builds on the foundation laid in this article. The video was created specifically as a follow-up to this article and take you deeper into more details.
Dr. Burns created a free video, no opt-in is even required, for your benefit. See the video here!
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If you’d like more in-depth training, I also offer a free trading course which focuses on the difference between how amateurs and professionals trade the markets.