Are the SET principles clear? Were you able to run the math to make sure you are able to win even when you lose more often than not? See in trading we don’t need to have a Ph.D. in math to be successful but we do need to understand the basics of odds and probabilities and that requires that we do a few calculations to make sure that we are on the right side of things. That is exactly what we are practicing when we run our numbers for Stop Loss, Entry, and our Targets.
This week I think there is some value in running a few more examples and incorporating some of the other things we learned from this blog since the beginning. The other items I am referring to are the different patterns that we learned about in the technical analysis section. The bullish retracement, the bullish breakout, the bearish retracement and the bearish breakdown. We will look to the markets to see if we can find a couple of example of these patterns and then run our numbers as if we are going to enter a trade on that particular stock.
Our first example is a bull breakout in TWLO. I have marked the Entry, Stop Loss, and the Target on the chart and the math and explanation are below the chart.
For this example, our numbers look like this… Entry is 10% of ATR above resistance. Resistance is at 42.50 and the ATR is 1.77. This means that after rounding up we would add $0.18 to 42.50 and that would become our Entry at $42.68. This gives us the confirmation we are looking for before entering a trade. Next up is our Stop Loss. We are using 1/2 ATR below support. After we breakout, the 42.50 level could act as support and therefore we would take our ATR, 1.77/2 and come out with $0.88. Minus that from $42.50 and we get $41.62. Since we are currently at the highest price we have been at in over a year then we need to come up with a reasonable price that may challenge the upward movement of this stock, that price is most logically the $45 level. It is the next $5 level above and the $5 and $10 levels tend to act a support and resistance for the large majority of equities. Now that we have our 3 prices we can figure out RISK/REWARD to see if this a trade we want to make.
RISK = Entry – Stop Loss = $42.68 – $41.62 = $1.06
REWARD = Target – Entry = $45 – $42.68 = $2.32
RISK/REWARD ratio = REWARD / RISK = 2.32 / 1.06 = 2.18
Therefore the ratio for this trade is 2.18 to 1. This meets our minimum requirement but may not be right for your system.
This example of a bull breakout should be easy to understand now and we are going to do a bearish example now as the concepts are the same but the math can be a bit more confusing as we have to flip the math upside down.
Take a look at this bearish breakdown example in DGLD and make sure you can follow the math as it is a bit different.
In this example, we must subtract instead of adding. This sometimes trips folks up but a little practice will make this easy. The math is as follows. The ATR for this equity is $1.05. This is our Entry = Support – 10% of ATR. Support is at 38.50 and the ATR is $1.05 so we need to subtract $0.11 from the support level which equals $38.39 as an entry price. The Stop Loss has to go above our support, the reverse to the previous trade. We add 1/2 ATR to the resistance level which after the breakout would be $38.50. So 1/2 ATR = $0.51 + $38.50 = $39.01. This is our Stop Loss. Our Target is similar to our above example except that we are going below as opposed to above. This equity is at the lowest its been in over a year and therefore we need to look for a reasonable level for a Target and that would most likely be the $35 level. We now have our numbers lets go ahead and calculate our RISK/REWARD. This is where things can get a bit tricky. Make sure to look at the formulas below and be aware of the switching.
RISK = Stop Loss – Entry = $39.01 – $38.39 = $0.62
REWARD = Entry – Target = $38.39 – $35 = $3.39
RISK/REWARD ratio = REWARD / RISK = 3.39 / 0.62 = 5.46
You can see from this calculation that this RISK/REWARD is better than the last few examples we have been seeing. This example is giving us over 5 to 1 REWARD to RISK. If your skill at picking direction is not as adept as you would like them to be then these are the types of trades you will be looking for.
You can see from these two examples that the math is not very complicated but it is essential to practice this math to keep you out of trades that are not within the bounds of our trading system. Now that we know how to do this manually, we will look at a tool next week that can simplify this process going forward. Until next time, keep practicing the math and it will become second nature and make you a better trader.
