- 2001: Volume 10, No. 4 Chartist Corner: Low Risk Trading

When deciding to buy or sell a security or commodity, it is easy to overlook a very key component of the trading decision—risk vs. reward. If a market is in a bull trend, selling the top of a corrective phase may seem prudent. However, if the downside potential profit is three points, for example, and the upside potential loss if wrong is 10 points, the trade simply does not make sense. Technical analysis can help analyze the risk/reward potential as well as point out immediately when a good trade goes bad.

What’s a Good Trade?
A few trend lines on a chart can identify when trading is excessively risky. A weekly chart of the Nikkei 225 Index in Japan (see Figure 1) shows a clear four-year 6500 point trading range from 14,500 to 21,000. Resistance at the top of the range is very powerful so selling at that level is low risk. The potential profit is 6500 points compared to the few hundred points of potential loss if this resistance ceiling is penetrated. If resistance is penetrated, the position is immediately reversed to a buy. With a rectangle pattern, it is not coincidental that the upside profit, once the small loss has been factored in, is still over 6000 Nikkei points.

Figure 1:

A more aggressive approach would be to anticipate a breakout from a consolidation pattern. With this strategy, we assume the pattern will be broken whereas in the above example we assumed that the pattern will hold. A daily chart of the Dollar/Mark cross (see Figure 2) showed an uptrend from the October 1995 low. It was caught in a rectangle consolidation pattern but two technical factors were pointing towards a continuation of the rally. First, prices failed to reach the bottom of the rectangle (which itself is a bullish sign) as they bounced off the longer term uptrend line. Second, the Relative Strength Index had already broken its own downtrend line and this usually leads a price trend break by one or two periods.

Figure 2:

The result is that we risk 125-130 ticks down to the trend line for a potential reward of 310 ticks as measured by the target for the breakout from the rectangle. In Figure 3, we see that this aggressive approach enabled us to capture the entire breakout day. Had we waited, we would have given up a large percentage of the total gain.

Figure 3:

March 1996 CSC Coffee is an example of how this approach resulted in a small loss (see Figure 4). Coffee had been in a down channel since April 1995 (not shown) and finally broke out in January 1996. It moved higher and then settled into a triangle consolidation pattern. A strong RSI plus an unrealized target of 155 based on a projection from the channel suggested a continuation of the rally.

Figure 4:

Buying at the close on February 23 was a low risk way to take a position before the inevitable breakout from the triangle. When the market fell apart in the middle of the next day, crashing through the bottom of the triangle, the trade would have been closed at a four to five point loss. When compared to the potential 30 point profit had the market broken the other way, the risk/reward ratio made the trade well justified.

Capitalization
The key to being able to follow an aggressive, yet low risk, trading approach is to be able to be wrong without going out of business. Taking a 100-point risk to make 300 is a good bet because it enables us to be in the market before the big breakout moves occur for maximum profit. The saying "ride the winners and cut the losses" really means that for every big winning trade, there are several small losing trades. Just like in baseball, a .400 batting average will put us on top of the game and make us very successful.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.