Setups, Triggers, And Risk To Reward Ratios

05/23/08 01:41:19 PM

by Alan R. Northam

A trader should not just jump into a stock position but should first define a valid trade setup, define his risk to reward ratio, and set the trigger price. GOOGLE (GOOG) is used here to explain how to properly enter a stock position to increase the probability of a successful trade.

Security: GOOG
Position: N/A

Many people who decide to buy stock do so based on hunches, news media, hot stock picks from market gurus, and so forth. However, the proper way to take a position in the stock market is by identifying valid trade setups, risk to reward ratios, and trigger points. There is no single correct trade setup; rather, there are hundreds of valid setups, and it is up to the trader to identify them. Trade setups identify high-probability points at which the market will move in a favorable direction. However, not all trade setups will move in a favorable direction, as some will turn and move in the opposite direction. Risk to reward ratios identify the risk being taken to earn a potential profit. The trigger point identifies the price at which to actually enter the market. The secret to trading success is to be consistent in identifying trade setups, risk to reward ratios, and trigger points, and entering and exiting the market based upon them. By being consistent, the trader has a high probability of overcoming the odds and being successful. In helping the trader learn how to identify high-probability trade setups, risk to reward ratios, and trigger points, I offer this one setup for GOOG for educational purposes only.

Trade Setup: Google made a market top in November 2007 and has traded downward and made a market low in mid-March. This downward move unfolded in five nonoverlapping waves. According to the Elliott wave theory, a five-wave movement in which waves 1 and 4 do not overlap and where wave 3 is not the shortest identifies the major trend. In the case of GOOG, this five-wave move has identified this market as being in a major downward trend, or bear market. This being the case, the market rally off the bottom that formed in mid-March must then be a corrective market rally and not the beginning of a new bull market upward trend. Again to the Elliott wave theory, market corrections occur in three waves, waves a, b, and c. The completion of wave c also completes wave (4) of five nonoverlapping waves, waves (1), (2), (3), (4), and (5). If this wave count is correct, then wave (5) down is yet to unfold and should not be completed until the market trades below the low of wave (3). Note that of the four completed waves, waves (1), (2), (3), and (4), wave (3) is not the shortest wave and that wave (1) and wave (4) do not overlap. Note also that wave (3) is made up of five subwaves, waves 1, 2, 3, 4, and 5, and that wave 1 and 4 do not overlap. Further, note that wave 3 is made up of waves (i), (ii), (iii), (iv), and wave (v), with wave (iii) not being the shortest wave and wave (i) and (iv) not overlapping. This is the fractal nature of waves. Wave 5 down also subdivides into five smaller waves, but I have not shown them. I have left that to the reader. Now note how close the peak of wave (4) is to low of wave (1). For the wave count to be valid and remain valid, wave (4) cannot move any higher without overlapping according to the rules of the Elliott wave theory. Therefore, we must consider the a,b,c corrective wave as being complete and wave (5) down is starting to resume.

FIGURE 1: GOOG, DAILY. The price chart of GOOG showing an Elliott wave count, 50- and 200-day moving averages, as well as the Fibonacci retracement levels.

Graphic provided by: StockCharts.com.

Trigger: Now that we have identified that GOOG has started to resume its downward trend, we must identify the point at which we will hypothetically enter the market. Note that Google has broken below and closed below its 200-day moving average now for two consecutive days and has made a low price of $540.25. As traders, we know that when a market moves below its 200-day moving average from above, the moving average turns from support to resistance, and the market is expected to continue to move lower. Therefore, this would be a good time to enter the market. However, as traders we also expect that the market may retest this new line of resistance so we might expect the market to move higher over the next day or so to retest the 200-day moving average as a new line of resistance. So we will set our hypothetical trigger point, the price at which we will sell short GOOG, just below $540.25 at $540. Now if GOOG moves higher on the next trading session, we will move our trigger up to just below the low of the next trading session. We will then continue to move our trigger up each day until it triggers and we enter the market. Let's say that the market continues to move down and our trigger is fired and we hypothetically enter the market at $540.

Risk: What if we are wrong and the market moves higher after we enter this market? This means that we immediately start losing money, which does happen from time to time. To account for this possibility, we must identify our risk. The point at which we will know that our trade setup is wrong is when wave (4) overlaps wave (1). Once this happens, we will know that our wave count is incorrect and the market may continue to trade higher. This will happen if the market moves higher than $616. If the market moves above $616, we will want to get back out of the market so we place a hypothetical stop-loss just above $616 or $616.25. Our risk then becomes the difference between our trigger price point of $540 and $616.25 or $76.25 dollars per share.

Reward: This is what we are hoping for. For the risk of $76.25 per share, we hope to make a profit. To define our profit, we have to look at how far the market may move in our favor. In the case of GOOG, we are hoping that the market will move in the downward direction. As to how far down we go back in the Elliott wave theory, Elliott says that wave (5) usually moves below the low of wave (3). Just how far below wave (3) this market will move, we cannot identify as of yet until wave (5) starts to unfold. What we do know is that wave (5) should unfold as five subwaves just like wave 3 did. Note that wave 3 unfolded as waves (i), (ii), (iii), (iv), and (v) did. So for now we will use the low of wave (3), or $412.11. In reality, the market should move below this price level, but we will use this price in determining our potential reward. Keep in mind that we don't have to sell at this price; we can let our profits continue to run. Therefore, our expected reward is the difference between our trigger price of $540 and our reward price of $411.11 or $128.89.

Risk to reward ratio: To determine the risk to reward ratio, we simply divide the reward of $128.89 by the risk of $76.25 and we get a risk to reward ratio of 1.69:1. A 2:1 ratio is about as low a ratio as I would want to take to enter a trade. If the risk to reward ratio is lower than 2:1, the trader should consider not taking the trade. The reason for this is that not all trades will be successful and will result in losses. Therefore, the trader needs to make sufficient profit with successful trades to make up for the losses of losing trades. Keeping the risk to reward ratio at 2:1 or better helps traders to overcome losses with their winning trades; 3:1 risk to reward ratios are even better. What we can do is lower our stop-loss price to improve our risk to reward ratio. However, this will increase our odds of getting stopped out if the market bounces a little after we enter the market before it decides to move down. The next logical point at which to set a stop-loss would be just above the 200-day moving average. Remember that this moving average should act as resistance since the market is trading below it. The 200-day moving average is sitting at $570.48, so let's set our stop-loss to $570.75 and recalculate our risk to reward ratio. The ratio is now 4.2:1. This is a much better risk to reward ratio and we can now take the trade, knowing that we have increased our odds of getting stopped out early. Note: Getting stopped out early is not the end of the world; we can always reevaluate the trade setup, recalculate the risk to reward, and redefine our trigger price and get back in at a later date.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

	Garland, Tx
Website:	www.tradersclassroom.com
E-mail address:	inquiry@tradersclassroom.com

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