As the name suggests, a trade with minimal loss with high profit probability is a low risk, high reward trade. Normally risk reward ratio of 1:2 is considered fair but for high reward trade, we should look for a risk reward ratio above 1:5.
Following five steps are required for planning and execution of low-risk high-reward trades:
1. Technical indicators and technical set-up
5. Closure of the trade
A successful professional trader looks for low risk high reward trades but it’s not that simple. To identify this type of trade, they adopt a combination of technical indicators to form a technical set-up. Selection of the technical indicators plays the most important role and is the backbone of the trading strategy. As there are many technical indicators, the main challenge is to identify the right one. What are the required characteristics of the technical indicator, will be concluded in the summary, once, we analyse the role of this set-up at each of above five stages.
Once the technical set up is in place, the next step is to identify a low risk trade. Let’s consider a buy trade. Risk will be low only if we enter a trade at the termination of down trend or just at beginning of a fresh uptrend. In both the cases, chances of the price going adversely are minimal and the level, to which, price can decline is also limited. The important question is how to confirm that this is the termination of a down trend or start of an uptrend. The most important characteristic of the technical set-up is the termination of a downtrend or start of an uptrend. For a low-risk trade, we must catch the trade near the bottom.
In the stock market parleys, it is very commonly said that “you cannot touch the bottom and you cannot catch the top”, but there are technical set-ups with very strong technical indicators, which can indicate the levels, when the stock is in downtrend, from where the trend is likely to reverse strongly.
The next step is planning for execution. A specific entry strategy is planned, which will ensure that the trade will trigger only if the trend is up. This is the second required characteristic of the technical set-up.
The next step of planning is monitoring. The first phase of monitoring is to cap the downward risk by putting a stop loss. In second phase, we trail this stop loss. As the stop loss moves above the entry level, we are ensured that the trade will close with profits. But the major hurdle in this exercise is the market volatility. In fact, volatility is an important factor, which can beat the technical set-up, if it’s not based on proper indicators. Those already in the stock markets are aware of the fact that volatility is one feature, which has defeated best of the traders with best of the strategies. Thus this is the third required characteristic of the technical set-up.
If the technical set-up can withstand market volatility, then nothing can stop closure of the trade with maximum profit possible. The last step of planning is to calculate the exit level. To identify the range for exit level is the fourth and last required characteristic of the technical set-up.
To summarise, it’s easy to plan and execute a low-risk high reward trade, provided the technical set-up can identify the termination of a down trend or the start of an uptrend, to ensure entry at the lowest levels possible.
The writer is a Sebi-registered investment advisor, also founder and CEO of www.tradingstation.in