MAILBAG QUESTION:

"I'm a trader based in Australia. I would love to know your views on risk/reward. My question is do you and guys like Mark Weinstein look at a set amount of reward to risk; i.e., a 3 to 1 return etc or do you take each trade on it's merits? Any feedback on this topic would be greatly appreciated. I find it easy to set my stops and stick to them but taking profits is sometimes the hardest."

MY RESPONSE:

Well, you're half-way there! Setting and adhering to stops is one of the biggest hurdles and downfalls of options and futures traders and it sounds like you have that part of the equation (RISK) under control. Next comes the challenge of exiting in the way you had planned to or not overstaying in a trade.

Generally, I have an objective on trades and TEND to exit when those objectives are met. Not always however. If the stock or index I'm in continues in a strong trend in my favor, I'll tend to set a NEW objective and look at the trade again when it nears that objective, assuming it does. I will however, raise my exiting stop to either be in a (hopefully) breakeven situation or to begin to 'lock in' a profit. A challenge with options is that adverse events can mean that I'm at the mercy of an adverse market opening and at such times I may wish I had gotten out at my original objective or target point so as to not have the aggravation of how I'm going to fare on unwinding my position.

I'm talking here about a STRONG trend and of course we want to ride a trend when possible. Mark Weinstein (see Jack Schwager's Market Wizards book) was more into taking profits at preset objectives. He could always get back in quickly and his cost of trades was very low at the level he traded at. I no longer sit in front of the screen all day and tend to rely more on following the bigger trends and don't like jumping in and out.

Let me use a recent example establishing risk to reward objectives when a chart pattern suggested that there would be a move of AT LEAST a certain amount. This first chart is one I used in my last (4/15/12) Trader's Corner. I like it because it was recent and the present objective looked like a safe bet for a downside objective.

Over the course of mid-March to early April, the S&P 500 (SPX) and other of the major stock indexes, formed the well-known Head & Shoulder's (H&S) pattern, in this case a TOP formation.

First up to consider are trade entry considerations. On the THIRD drive above 1410 which formed the Right Shoulder (RS) of this pattern, SPX was looking more and more like it was forming at least an interim top. Aggressive traders who were savvy to the H&S pattern and I tend to agree with this stance, might sell on the 3rd drive to around 1420 as the overall pattern of 3 rallies that trace out the Head & Shoulder's is such a reliable top pattern; so also is at bottoms in the often named 'reverse' H&S bottom.

The exiting stop point in our example here is going to be a little above the middle top (the Head); 1425 is good. Since the neckline hasn't been broken yet, the stop is set in relation to the pattern. If the H&S Top pattern is 'true' so to speak, the index is not going above the top of the prior high or not by much; it may overshoot by a little.

The other ENTRY option is to wait for a break below the 'neckline' of the pattern and then go into puts there. Trade entry is not going to be as favorable on long puts once prices break down like this and put premiums shoot up. However, risk to reward, assuming the 'minimum' downside objective, isn't bad at this point. The same SPX hourly chart as seen above is shown again below.

A 'minimum' downside objective for a Head & Shoulder's Top, once the stock or index pierces the neckline is to subtract the distance from the top of the Head to the 'neckline' and then subtract that amount from the point at which the index later pierces the neckline; this point is highlighted as the 'breakdown' point. This calculation results in what in technical analysis terms is considered a minimum downside objective; here, it's the 1368 level.

Assuming I took a more conservative course of buying SPX puts at the 1395 'breakdown point' relative to a target of 1368, makes for a potential objective of at least 27 points. I would need to set my exit point at 1403 to adhere to a 1 to 3 risk to reward equation based on a 1368 target. Shorting near the 1420 area ended up making for an even more favorable risk to reward.

NOW comes something going to the heart of your question. Do I exit when my present objective is hit as highlighted above or do I start anticipating that the Market is going to take an even BIGGER hit and go down significantly more. NO WAY!

I'm going to exit when SPX trades to and through my 1368 target. # 1.), 1368 was my target and it was reached so take the money and run. That was the plan and we should work our trade plans. Reason # 2 for getting out at the downside objective is that this was a counter-trend trade. The trend has been UP and is still UP on a longer-term basis. Going into SPX puts, I'm trading AGAINST the dominant trend so all the more reason to adhere to my strategy and exit the short side (puts) at my trade target.

Let me take an example of a risk to reward projection of a trade where I was trading in the SAME direction as the dominant trend and where it might be prudent to stay with the trend, especially if my entry was right. Mark Weinstein used to talk about getting in 'right' or 'buying right'; he usually was buying index calls or puts at points he perceived were at extremes and likely to be significant turning points in the trend. Buying 'right' meant you could calculate or reasonably anticipate that the risk (relative to reward potential) ratio was highly in your favor and that normal fluctuations wouldn't get you stopped out prematurely. That the amount risked was very small relative to the reward potential if right on timing and direction.

My next chart is of the Nasdaq 100 (NDX). First, NDX (finally) got to a 'fully' oversold extreme in terms of its 13-day Relative Strength Index or RSI back in December. Just when you could anticipate a possible 'santa claus' rally to follow; ok, forget Santa, but seasonally, year end tends toward an advancing trend. It wouldn't necessarily be prudent to buy NDX calls solely on the basis of an 'oversold' extreme. In that case WAIT to see what the first (downside) correction would look like.

When the first correction came, NDX retraced 2/3rds of the initial run up and is a favorite buy-in point of mine, since I'll risk to not far under that 66% retracement point equaling a relatively small risk. If the trade works out, by there being a second up leg, my risk (to my close by stop) is quite small relative to the upside potential in a second up leg; which of course occurred with NDX big time. My upside objective (reward potential) was just a loose assumption that the upside potential should be 3 to 4 times the risk I took on my stop-out (exit) point. I didn't have a preset objective beyond that.

As NDX took off in that very strong multimonth trend see above, I was drawing (and redrawing) an up trendline and it was what I call a very 'well-defined' trendline; as if it had eyes, declines stopped at or above the emerging up trendline. You could just keep raising your stop-out/exit point to what would be a trendline break or penetration. When this finally happened, EXIT!

An aggressive trader might get back in on the rally back above the up trendline (see above), but I personally wouldn't favor that trade so much as generally I don't want to be long a stock or long index calls when the market is at overbought extremes. Sooner or later the trend is going to stop maintaining that degree of ascent that a trendline represents.

At a minimum, prices will go sideways, price swings will get choppy and so on. I'd rather buy back in at some point after at least a 'minimal' pullback/retracement (e.g., a third to a Fibonacci 38%) of the last advance and when the index or stock in question is no longer showing at an overbought extreme. This is my general rule of thumb about trading WITH the dominant trend UNLESS a chart pattern forms that suggests a tradable decline such as with my initial chart example with the SPX top pattern (the H&S Top), I favor trading with the longer-term trend.

LAST BUT NOT LEAST:

You may recall my chart of the major uptrend channel that Apple Computer (AAPL) traced out over 3 years and the progressively wider channel lines that that strong uptrend suggested. The WIDEST possible topmost trendline was the third such line and where I assessed that the rally would eventually end or least begin a significant correction. Speaking of technical objectives, a move to the 650 area became my ultimate target for AAPL.

Selling into resistance implied by the upper end of the channel seen in AAPL's weekly chart below, is looking to be at least the right place to have taken profits on the stock. Nothing goes up forever as stocks discount all possible good news then goes way beyond that to an extreme overvaluation. Tech stocks, we love em!


GOOD TRADING SUCCESS!