• Sat. Jun 15th, 2024

If the common risk-to-reward approach isn’t working: Try this transformative ‘market language’ strategy

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Ever played the game Chinese Whispers?

Keep reading to discover how it has corrupted the real meaning of risk to reward.

In Chinese Whispers, a message is whispered from person to person. With each pass, slight variations occur until the final “version” is a mutated form of the original—missing key points and including invented ones.

Similarly, a mutation has corrupted the common understanding of risk-to-reward. And this misconception is harming most traders.

Let me illustrate with an actual trading example. But first, let’s break down the flawed risk-to-reward understanding:

The typical approach goes like this: enter at $10, risk $2, target $16. A 3:1 reward-to-risk ratio sounds great, so you put on the trade.

What happens next?

You realise your target is seldom reached. Right? Maybe it works once in a blue moon, but mostly, this unfolds:

If the market moves in your favour, it inevitably retraces and stops you out before hitting the target. So you try using trailing stops, break-evens, scaling out… But you still end up losing overall more often than not.

And for some, you get so frustrated at being stopped out before the target you resort to…averaging down. And just like that you’re playing Russian roulette with your account.

What’s the problem?

There are two critical issues.

First, the market tells you how far it can go—but you’re not listening. Not because you don’t want to, but because you don’t comprehend its language.

Second, you lack a playbook of strategies enabling ideal trade entries—when odds favour an immediate move in your direction seven out of ten times.

For the remaining three out of ten times, price doesn’t move favourably right away. But it only needs to budge insignificantly for you to know you should exit. Think of this as a paper cut that isn’t detrimental to your account.

(Quick clarification: An initial move in your favour doesn’t guarantee a profitable trade. But it does create a cushion of profit. You can use this cushion to avoid a losing trade.)

Why is trading structured this way?

Simple. The trading game is deliberately opaque—to ensure the majority of traders lose to pay the few who win.

But what if you know when to enter and when to exit because you understand how the market communicates when to act? Using recent trading in the AUDUSD futures traded on the CME, let me illustrate.

On May 16th, our plan allowed trading the short side but only as far down as 0.6664.

There was no profit target—just a defined invalidation point for short trading, i.e. “No Longer Short.” at 0.6664. But see how the trade ended well before reaching this price?

PS: Do you also see how the short entry works immediately?

Chart

Our plan continued into May 17. But this time price moved as far as our plan would allow for short trading. The price got close enough to 0.6664, and the trade was closed.

PS: Do you also see how the first short entry is a papercut loss?

Chart

And here’s a side-by-side comparison of both days. No pre-determined profit targets.

PS: Do you also see how the exits hold onto your profits?

Chart

You’re no longer wrestling with:

  1. Not knowing when to take profits because the market has gone as far as it can.
  2. Timing your entries for an immediate cushion or papercut loss.

Below is a photo of my trading station. The many windows you see are used in concert to know, listen, and comprehend what the market is saying.

Chart

Overwhelming?

There’s no need. Just like juggling, you start with two then three, then four etc.

Your aha moment?

If you know the best action to take because you can comprehend what the market is saying, then its transformative for your trading. Agree?

In summary

Risk-to-reward ratios are delusional because trading is about probabilities revealed through understanding the market’s language. That’s why a battle-tested playbook of strategies is vital —both for strategic entries and avoiding either exiting too soon or exiting too late for your profits.

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