Defining Reward/Risk Ratios With Chart Setups In The Futures Markets

One of the critical tasks traders face is finding setups appropriate to their risk profile and then making a trading plan for each trade. You can use  common chart patterns to estimate the reward and potential risk of a trade. This will give you a quantitative method for analyzing whether a given futures trade meets your trade selection criteria.

As most traders know, futures and stocks repeat price movements with sufficient frequency that the patterns they trace are identifiable, have names and are tradeable. The fact that price behavior repeats, allows one to calculate the move a futures is likely to make once a new pattern setup emerges. 

The point-value that a futures is likely, or predicted, to move is called a "measured move." Research shows that futures contracts have a high, and statistically significant chance of moving to the measured objectives in the following pattern setups. The measuring objectives are conservative for these pattern setups, but bear in mind, these are guidelines, not hard-and-fast rules. And of course, honor the stops. 

Estimating reward-to-risk ratios is useful because it helps you plan a trade by determining your entry-point, stop-loss and exit objectives. By establishing your goals for the trade, you also can determine if the trade provides a suitable return for your risk tolerance. The reward-to-risk ratio is calculated by taking the price objective and dividing by the stop (risk), i.e., measuring objective/stop = reward-to-risk ratio. 

My minimum reward-to-risk ratio criteria is 3-to-1. 

In this lesson, we will look at three common chart patterns: the head-and-shoulder bottom, the double bottom and the descending triangle.

Head-And-Shoulders Bottoms

The calculation of the price objective (reward) and stop (risk) is straightforward. A long position is entered on the break of the neckline. For the head-and-shoulders bottom pattern, the measuring objective is twice the distance from the head to the neckline. The protective stop is placed four ticks below the stop-loss line and represents the risk. The stop-loss line is created by drawing a line from the head to the right shoulder.

In the example below in August unleaded gasoline (HUQ0 | Quote | Chart | News | PowerRating), the distance from the head (.7008) to the neckline (.7765) is .0747, giving a measuring objective of .8522 (.7765 + .0747). The stop is placed four-ticks below the stop-loss line at .7655 and is equal to .0100. Hence, the reward-to-risk ratio is .0747/.0100 or 7.5-to-1, a setup which exceeds my 3-1 ratio minimum. The calculation for a head-and-shoulders top is, of course, the inverse of a head-and-shoulders bottom. 

Double Bottoms

For double bottoms, the measuring objective is the distance from the bottom of the double bottom pattern to the resistance level above the double bottoms, above the "peaks," if you will. The stop is placed below the resistance/breakout level and is slightly arbitrary in its determination. I usually place the stop at a confluence of recent lower highs and closes below the resistance. 

In the following setup in September T-bonds (USU0 | Quote | Chart | News | PowerRating), the distance from the double bottoms (92 20/32) to the "peak" resistance (94 17/32) is 61 ticks (94 17/32 - 92 20/32), giving a measuring objective of 96 14/32 (94 17/32 + 61/32, or 1 29/32). The stop chosen below the confluence of recent lower highs and closes below the resistance (designated by the oblong circle in the chart), is at 94 5/32, a distance of 12 ticks. Hence, the reward-to-risk ratio is 61-ticks/12-ticks or 5-to-1. Calculations for double tops can be determined similarly and also apply to triple top and triple bottom setups. 

Descending Triangles

For descending triangles, the measuring objective is twice the height of the triangle, calculated from the high of the pattern to the support, or base, of the geometric figure. The stop is placed above the descending line of the triangle (the hypotenuse).  Of course these patterns and ratios occur and can be determined in multiple time frames. The following example is with Nasdaq 100 futures (NDU0 | Quote | Chart | News | PowerRating) using 5-minute bars. This example applies to E-mini Nasdaq 100 futures as well.

In this example, the distance from the high of the pattern (3810.00) to the base (3750.00) and breakout point is 60.00 (3810 - 3750), giving a measuring objective of 3690.00 (3750.00 - 60.00). The stop and risk is above the descending line of the triangle at 3770.0 and is equal to 20.00. The reward-to-risk ratio here is 60.00/20.00, or 3-to-1. Again, this matches my reward-to-risk requirement.

Notice in the descending triangle example that the NDU0 did not continue through to the apex of the triangle. Ideally, the futures will breakdown approximately two-thirds of the way into the pattern. This results in a higher likelihood of follow-through to the measuring objective. Here, the NDU0 achieved the measuring objective by the end of the session and traveled nearly that distance on the following day.

Using chart patterns to calculate reward-to-risk ratios will assist you in planning your entry, stop-loss and exit points and will keep you from taking trades that do not match your trading objectives.

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