What is Missing in Your Risk Analysis?
Risk Analysis vs. Run Gain Profit Potential
The least used and most often improperly used analysis by Technical Traders and Retail Traders is Risk Analysis. All too often, traders are choosing high risk stock picks without realizing it.
This analysis is NOT using percentages, but rather using the technical patterns within the chart in order to do the following:
- Find the lowest risk trade from a group of potential stock picks.
- Determine the risk versus the Run Gain Profit Potential BEFORE placing an order.
- Determining the correct stop loss placement to avoid setting the stop loss at a whipsaw point, or not using a stop loss at all due to not knowing how to use and set them correctly.
- Selecting the strongest picks based on Risk Analysis, which reveals weaknesses in stock picks that do not show up in Candlestick Patterns or MACD Patterns.
- Choosing stocks with risk that you can tolerate. Too many times traders get greedy, and choose picks that have higher risk than they are ready to accept.
First of all, stop losses should NEVER be calculated using percentages. This is an ancient, out of date method that is the main reason why so many Retail Traders believe that stop losses do not work.
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They are accidentally and unintentionally setting stop losses based on a percentage that puts them right in the middle of a profit taking area where High Frequency Trading will trigger, OR where Dark Pool bargain hunting Time Weighted Average Price orders are sitting and waiting for price to drop into that range.
Trading the automated markets along with Market Participant Groups that use Time Weighted Average Price orders, Volume Weighted Average Price orders, and High Frequency Trading predatory millisecond orders requires using MODERN analysis and tools. It is hard to abandon techniques learned on the internet that appear everywhere but in order to be successful, traders need to change how they approach trading.
When choosing a stock to trade among a group of stock picks, consider the risk of the trade based on technical support levels appropriate for your Trading Style. Trading Styles include Intraday Trading, Swing Trading, Swing/Momentum Trading, Position Trading, and several others.
Strategies are selected AFTER a Trading Style has been chosen. Certain Trading Styles require specific technical patterns, candlesticks, and support levels for optimal trading success. Buying Long versus Selling Short also changes support and resistance levels for each Trading Style.
As an example of Risk Analysis see the stock chart below, which has an Engulfing Black Candlestick Sell Short signal.
As a Sell Short pick consideration, the chart shows that the resistance is above price as indicated by the red line. This is where the stop loss must be set rather than a percentage. A tight percentage puts the stop loss in the middle of the resistance which will create a whipsaw, and a larger percentage such as 8% or 10% puts the stop loss far too wide adding risk to the trade.
The next area of calculation must be the support, which is where the stock is likely to bounce up as indicated by the green line. This may not hold over time, but is the first level of support for this stock if it sells down further. Support therefore is based not on a percentage but the technical levels where bounces occur from Buy to Cover Professional Traders closing their position, OR from “Buy on the Dip” Small Lot Investors rushing to buy into what they believe is a bargain.
By calculating the difference between the resistance and the entry price, the risk of the trade is determined. By calculating the support level where the stock is mostly likely to pause or bounce, the Run Gain Profit Potential is determined. The final step is dividing the points at risk by the points Run Gain Profit Potential. Risk to profit should be 3/1 or higher. Most of the time Retail Traders are trading stocks with higher points at risk than there are potential points to gain.
Taking the time to calculate risk using Risk Analysis will significantly improve your profitability by eliminating high risk and low profit trades.
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Martha Stokes CMT
TechniTrader technical analysis using a MetaStock chart, courtesy of Innovative Market Analysis, LLC dba MetaStock
Chartered Market Technician
Instructor & Developer of TechniTrader Stock & Option Courses
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