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The Reward-Risk Ratio (RRR) is an essential and fundamental component of the Order-Management Strategy. The purpose of RRR is to pinpoint and validate the market prices for the most profitable trading opportunities. The higher the value of RRR, the more fruitful would be the trade. Its main contribution to the trading-checklist is the provision of a “go” or “no-go” signal before placing any order. It verifies that the expected gain relative to potential losses is significant enough to justify placing of orders. Furthermore, it ensures that we use the support and resistance trend lines for the Open and Close prices. Finally, it minimizes the risk of overtrading. Before determining the Reward-Risk Ratio, it is necessary to predict the ongoing market trends. We do it by applying the Trend-Prediction Strategy. Application of the TPS is a pre-requisite for calculation of RRR. We assume here that you are already familiar with the TPS.
Let us take a theoretical example for the sake of understanding the concept. We assume that the market is within a horizontal channel with the support at 100 and the resistance, at 120. This results in a channel range of 20 points. Here we empirically assume that if the wave goes 2 points below the support level of 100 or 2 points above the resistance level of 120, the market contradicts the originally predicted market trend.
The procedure to calculate the value of RRR for a Long position would be as follows:
The Open price for the trade will be US$ 100.
The Close price would be US$ 120.
Total potential gains would be US$ 20 per share or 20 percent of the invested capital.
The Stop-Loss would be at 98 (100 -2). The total potential loss per share would be 2 points or 2 percent of the invested capital.
With the above example, the value of RRR is 20 divided by 2, equals 10.
It is essential to understand that while the price fluctuates between 100 and 120, the RRR value varies accordingly. For example, when the price is at 105, the RRR would shrink to (120 – 105)/2 = 7.5. The RRR still validates the order. However, if we want to open a Long position at a price of 115, the Reward-Risk Ratio would be (120 – 115)/2 = 2.5, hence too low. Therefore, the RRR would signal a “no-go” for the order.
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