Risk reward ratio Understanding RRR in Dow Theory

The Reward to Risk Ratio (RRR)

The concept of Reward to Risk Ratio (RRR) is not exclusive to Dow Theory; being a generic tool applicable to all types of trading. Hence, we will discuss its use in this context, with it finding application across trades based on technical analysis or investments employing fundamentals.

This short-term long trade can be quickly analysed using a reward-to-risk ratio calculation. All the details must be considered to make sure this is a sound investment.

Entry: 55.75

Stop loss: 53.55

Expected target: 57.20

At first glance, this brief trade may appear acceptable. 

What is the risk the trader is taking? –  [Entry – Stoploss] i.e 55.75 – 53.55 = 2.2

What is the reward the trader is expecting? – [Exit – Entry] i.e 57.2 – 55.75 = 1.45

Here’s what it means: 

For a reward of 1.45 points, the risks 2.2 points. In other words, the Reward to Risk ratio is 1.45/2.2 = 0.65. This is clearly not a great trade. 

A good trade should be characterised by its RRR being favourable. That is, the expected return should be at least 1.3 times the risk taken or better. Otherwise, it’s not worth pursuing.

For example, consider this long trade:

Entry: 107

Stop loss: 102

Expected target: 114

In this exchange, the risk taken on is Rs.5/- (107 – 102) for an expected return of Rs.7/- (114 – 107). This returns a RRR of 1.4, which is favourable to the trader – it implies that they expect a reward greater than their risk. A not bad bargain.

The RRR threshold should be set according to one’s risk appetite. For example, I would not feel comfortable with a ratio lower than 1.5. Some more daring traders may take on trades with an RRR as low as 1, meaning for every unit risked, they would expect the same amount in return. Others may prefer a lower ratio of 1.25. On the other hand, very cautious traders might opt for an RRR of at least 2 – meaning for each unit of risk, they would want to receive double the amount back.

A successful trade must meet the RRR criteria. Remember, a high RRR is essential for an investment that gives returns. Ultimately, if the RRR cannot be satisfied, then an attractive trade must not be pursued due to its potential risks.

To gain an understanding of the context, consider this theoretical example:

A bearish engulfing pattern was discovered near the highest point of a trade, coinciding with a double top formation. Volumes were significantly higher than ten-day average levels, estimated to be around 30%. The chart also indicates medium-term support close to the bearish engulfing pattern’s peak.

The situation appears to be ideal for initiating a short trade; the trade details are listed below:

Entry: 765.67

Stop loss: 772.85

Target: 758.5

Risk: 7.18 (772.85 – 765.67) i.e [Stoploss – Entry]

Reward: 7.17 (765.67 – 758.5) i.e [Entry – Exit]

RRR: 7.17/7.18 = ~ 1.0

I noted above that I must maintain a RRR of at least 1.5, so while the trade looks promising, I’ll be content to move on and seek out the next option.

It’s clear that RRR is part of the required items.

– The Grand Checklist

Having considered the technical analysis elements, let’s revisit our checklist and finalize it. Of course, Dow Theory is crucial in confirming a trade and should be included accordingly.

1. The stock should show a distinguishable candlestick pattern.

2. S&R should be taken into consideration when confirming a trade. The stoploss price should ideally be in the vicinity of S&R.

1. To make a lasting trade, it is advisable to locate the lows of the pattern near the support.

2. For a brief trade, it is recommended that the peak of the pattern is close to the resistance.

3. Volumes should confirm 

1. Ensure higher than usual volumes of buying and selling on both days.

2. Low volumes are not encouraging, and hence do feel free to hesitate while taking trade where the volumes are low.

4. Look at the trade from the Dow Theory perspective.

1. Primary, secondary trends

2. Double, triple, range formations

3. Recognisable Dow formation

5. Indicators should confirm

1. Increase the trade size if signals indicate that it is in line with your strategy.

2. If the indicators do not support it, stick to the original plan.

6. RRR should be satisfactory

1. Consider your risk tolerance and set a limit for your RRR

2. For a complete beginner, I would suggest the RRR be as high as possible as this provides a margin of safety.

3. Meanwhile, the RRR should be at least 1.5 for an active trader. 

Once you have identified a potential trade setup, assess it from the point of view of the Dow Theory. If a long position is indicated using candlesticks as a guide, take note of what the primary and secondary trends are indicating. A bullish primary trend suggests that this would be a good move; however, if we are currently in the midst of a secondary trend that is contrary to the primary one, it may be wiser to tread carefully since the immediate trend is not in line with your desired outcome.

If you take the advice given in this checklist, and really grasp its importance, your trading is sure to come along in leaps and bounds. The next time you decide to enter a trade, make sure you adhere to these guidelines – it’s the only way to ensure your decisions are based on sound judgement rather than guesswork.

– What next?

In this module, we explored many areas of technical analysis. I am sure you have gained a strong base from the topics we discussed here. It is possible that there are other patterns and indicators not mentioned here, however, it is for a certain reason. Thus, be assured that you are equipped with everything you need to start your journey in technical analysis.

If you spend time getting a great grasp of each concept, you can be confident in setting up a robust TA thinking structure. From here, the next step is to investigate the thought processes behind testing trading strategies, risk management, and psychology related to trading—those will all be looked at in the following sessions.

In the final chapter, we will discuss a few practical steps that can aid you in beginning Technical Analysis.