Trading is often considered a risky business. But, no one denies that there are also great rewards to be found in the markets. This dichotomy appears in every trade made. The key to making good futures trades is to understand this fact, and calculate the risk to reward ratio of all futures trades you make. You need to know what the likely return of the trade is if it goes according to plan, and how much are you likely to lose if it doesn`t. You need to know this before you make one or more futures trades.
In order for futures trades to make sense, it`s potential reward must outweigh its potential loss by as much as possible. Obviously, if a futures trade is more likely to fail than succeed, you shouldn`t make the trade. If the futures trades are equally likely to succeed or fail, it`s not a trade worth making either. If success is only slightly more likely than failure, you`re at least on the right side of the risk to reward ratio, but is it really worth it? If there`s no good trading opportunity in sight, wait until one appears.
How do you figure out the potential reward and the potential risk? You can determine the reward level by evaluating the strength of a futures stock, by tracking the outcome of similar futures trades made on other futures stocks for the same reason, an equivalent trend, by considering market conditions, and last by examining the technical and psychological resistance levels you see for the futures stock.
If, for example, you want to trade a particular futures stock based on a trend you`ve observed in four other stocks, which would mean you have a good, compelling reason for the futures trades you are considering, you`ll first judge the company`s strength. Check to see if it`s a leader in its sector that always has good earnings and tends to run up strongly during market rallies. Let`s say, for this example, that it does. Then look up the range of percentage returns those other four stocks gave. They are between 8 percent and 22 percent. Then, consider the market conditions, which are becoming more bullish. Last, check the resistance levels for the futures stock. Right now, it`s trading at 18 dollars; it`s got technical resistance at around 23 dollars, and although a little psychological resistance may appear at 20 dollars, it`ll be more of an issue at 25 dollars and certainly at 30 dollars.
A 10 percent rise in the futures stock`s price would bring it to slightly below 20 dollars. Since the futures stock and the market are strong and four other futures stocks have given good returns on this strategy, and since the futures stock has been as high as 23 dollars before, it`s reasonable to anticipate that the stock could see 23 dollars if it goes on a strong run. That would be a return of over 25 percent. It looks like the potential return on this trade is somewhere between 10 percent and 25 percent, with it likely to be higher end.
And what`s the potential loss? That depends on where you set your stops. Stops are a critical part of your trading plan, and should be given careful consideration. For this example, let`s say you don`t think the futures stock is likely to go down past 17 dollars, since the chart shows strong support there. If you set your stop just below 17 dollars and it ends up being triggered, your loss will be about 6 percent. That`s somewhat high, but since it looks very unlikely that the futures stock will head down that far, the risk of loss is not actually that high.
So, this trade gives you a probable upside of at least 10 percent and as much as 25 percent, with a relatively unlikely downside of 6 percent. This is a good risk to reward ratio. If you have a good reason for every trade you make, and make only futures trades with risk to reward ratios that are very promising, you maximize your chances for long term success.
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