The Importance of “R’s” in Trading.

We have talked in the past about the importance of using an “R” value for both your risk and your reward. If you select trades with a favorable “R” ratio (minimum 1 to 3 risk/reward), you can be wrong over 70% of the time, and still break even. And if you are right more than 30% of the time, you will be consistently profitable on your trades. Let’s take an example of a trade in RIMM (Research In Motion, Ltd.) from Friday, to see how using “R’s” in trading plays out in the real world.

This first chart is of RIMM going into Friday, before the open. RIMM is a usual watchlist suspect, and from our overnight analysis, we have mapped out four S/R levels on a 15 minute chart. The chart shown is a 3-day chart and although previous days levels can be important, the most relevant is the preceding trading day’s levels. The S/R levels are the high of the day (A), The low of the day (D), and two interday pivot points (B and C). These are points we will use to look for entries both short or long, on breakout or reversal trades.

Our second chart shows the most important time of the day, the opening range. This range is key because it sets the upper and lower S/R levels after all the overnight buy and sell orders have been executed. For breakouts, we are looking to go long above the ORH (opening range high) and short below the ORL (opening range low). For reversal trades, we are looking to go short, below the ORH, and long above the ORL. The OR is set by the first 15 minute bar, as that is the time frame chart we are trading. The ORL exceeded the low of the previous day, so we have reset S/R level D, as this low is now more relevant than the previous day’s low. The ORH was just short of S/R level C, a previous day’s intra-day pivot point, and as the OR is more relevant, we have adjusted this level down just slightly.

Now we see that on the second bar, price tries to break above the ORH, but cannot hold, and is turned back. Bars three and four continue to pull back, all on declining volume. Bar four breaks below the ORL, but reverses sharply, on slightly high volume, and creates a green bullish hammer, that finishes above the ORL. This is our signal bar, and at this point we will determine our “R” ratio, to see if the trade is worth taking. This signal candle has a high of $57.23 and a low of $56.60, a spread of $0.63. The conservative, and technically correct “R” is to place a stop buy order $0.02 above the high of this candle, and a stop sell $0.02 below this candle. This gives us an “R” risk of $0.67. However, with a reasonable first target being the ORH at level C ($58.30), or a $1.05 reward, we are only looking at a 1/1.5 risk/rewarded ratio at best. This is not ideal, and we have three possible choices. Pass on this trade, take the trade, with perhaps a lower $ risk due to the lower reward target, or adjust our chart based risk amount. The last option is what I chose to do. With the ORL being a fairly solid S/R level, I choose to place a stop buy at $57.25, and a stop-loss $0.02 below the ORL of $58.00, with the added support of the round number coming into play as well. This gives me a risk of only $0.27, and a potential reward of $1.05, or almost 1 to 4.

My buy stop is hit on the next bar, and initially, the trade moves in my direction, and of course, I am the greatest trader the world has ever known. But then reality sets in, and price stalls, and move back down past my entry, and towards my stop-loss point.  Though price comes within $0.02 of my stop-loss, the ORL holds, and price bounces and continues to consolidate. Price finally starts to move up on bars nine and ten, with a slight increase in volume. However it is bar eleven, where the move starts to accelerate. This is a very large bar, and as it approached the first target level, a decision needs to be made. There are three choices. Close the entire position out for almost 4R profit, let the position run, or do what I chose to do, which was to sell half my position at the target price of $58.30, and let the rest run. The decision to let half run, had to do with the general strengthening of the overall market at this point, as well as the strong move for RIMM off the ORL. I put a stop loss $0.02 below the low of the eleventh bar, as this would be more than a 50% retracement of the move off the ORL, and a sure sign the trade was over. By putting the stop there, I am risking 1R of my profit (2R x 1/2 position), so worst case scenario, I have locked in a 3R profit for this trade.

Price indeed stops at the ORH, pulls back and consolidates in a sideways manner between bars twelve to twenty (the spike on bar fifteen is a data spike, price did not trade through it, and thus the stop did not get hit). Then on bar twenty-one, there begins a slight move up towards the ORH, all with small green narrow range (NR) bars and mini hammers. These bars all close above the 5MA which provided support, and I moved my stop up, trailing it below the bottom of each progressive candle, as resistance at the ORH was coming up, and more so because it was getting late in the trading day, and I wanted to lock my profit in on any reversal. Bar twenty-four finally broke and closed above the ORH, although volume was not impressive. At this point, the stop is moved up to just below the ORH. It is rare to be in a trade this late in the day, as the probabilities of a non-functioning trade suddenly going in your favor are slim, and there is not much time left for the trade to work out if it does. However, since we only have a half position open, and we have locked in our profit (4R at this point), there is no risk in keeping it open.

And fortunately, on bar twenty-five, we get a late day gift. Price moves up to $58.83, and closes at the high of the bar. Although the bar finishes a bit short of the price target at S/R level B, when you get a gift like this on the second to last bar of the day, you don’t get greedy and hold out for more, you close it, which is what I did at $58.80. Holding the second half of the position got us almost 1R more, for a total of 5R profit on the trade.  This is a trade the Wall Street Warrior would be pround of (I think).