The following article aims to provide:
- Information on Enhancer #3: Profit margin and reward ratio
- The difference between profit margin and reward ratio, and how to evaluate them
In the previous articles we have seen how important the strength of the initial move is regarding the level it leaves behind, how to look for new levels to trade, and why their placement in the big picture plays a huge role in determining whether a level has a high probability of producing the reaction we desire in order to give us a lower-risk higher-reward trade. All trade enhancers are inter-dependent and are meant to only work together and not individually, so it is no surprise that the third one is expanding on the previous two. The profit margin is a concept that is relevant to any business, and trading Forex is a business too even if you are trading for personal account. In trading you are probably more familiar with the similar term "Reward ratio", which is quite similar in this context and could even be used interchangeably in some cases, although it would be more appropriate to say that the profit margin (expected reward) is required in order to calculate the Reward ratio of the trade.
A simplified way of describing your profit margin would be that it is the difference between the price you buy and the price you sell (minus expenses of course). No matter which comes first (buy/sell) and no matter which market you are trading (Forex or any other), the difference between these two prices is your profit, or if negative, your loss. So when entering a trade with the purpose of making a profit it is absolutely relevant to know what your expected profit margin is. No need to over-complicate things, knowing your profit margin can be as simple as finding the nearest opposing Supply or Demand level which is strong enough (and so it has the potential to act as a ceiling to the profit of your trade, or even to eventually turn it against you).
Knowing your profit margin can be as simple as finding the nearest strong opposing Supply or Demand level
But that is only half way to knowing your Reward Ratio because in order to calculate that you also need to know how many pips you are risking in order to get the reward. So basically you need to figure out the minimum distance in pips that you normally expect your trade to run (i.e. to the opposing level), and how many pips you have to risk in order to get into this trade (which is largely dependent on the thickness of your level). The actual amount you choose to trade is a different matter discussed elsewhere, but it equally affects both sides (risk/reward) so it does not affect the ratio of the two, thus it is not directly related to this article.
Before you enter a trade based on an otherwise evaluated level, and since you should have already verified that the level is not overridden by a larger opposing level on a higher timeframe (the big picture), you also need to check your profit margin in order to make sure that your trade truly makes sense. If it doesn't make sense from a financial risk perspective then you have to discard the trade and simply look for the next one. Don't make the mistake of thinking that your profit margin is unlimited, very high, high enough, or that you should determine it after entering the trade. Although you could let your trade run for as long as your circumstances allow, that would be a novice mistake and a recipe for trouble. Determining your profit margin and reward ratio in advance of the trade entry is a completely different matter as compared to how long you might eventually let your trade run, and it should be taken seriously as it plays a role in determining how well you have stacked the probabilities on your side of the trade.
So in order to evaluate the Reward ratio of a proposed trade we can start by determining the profit margin, which is the distance to the nearest opposing level which is capable of causing an adverse reaction. Have in mind that since Supply and Demand trading is anticipatory analysis which can be done much in advance, you should re-examine the trade as price is reaching closer to your candidate level. As expected, price can form new opposing Supply or Demand levels while on the way back to your level, and these opposing levels are exactly what is limiting your expected profit margin (if they still remain valid unused opposing levels when price reaches yours).
These opposing levels are exactly what is limiting your expected profit margin (if they still remain valid unused opposing levels when price reaches yours)
So the profit margin is something that should be re-checked just before your level is hit just in case newly formed opposing levels affect your trade. You could evaluate these opposing levels in the same way as any other level in order to evaluate their strength, but if you are certain that your level is on the correct side as suggested by the big picture, and these opposing levels do not seem to match any of the requirements for trading (for an entry), then you might be dealing with a weak or invalid opposing level which can be ignored. Although the creation of last-moment opposing levels is quite common, you will find that most of the time these are not valid as price frequently manages to return to them, thus taking them out by touching them soon after their creation (more about fresh/untouched levels in the next article). If you are not sure if a possible opposing level is valid or strong, then it is safer to respect it and assume that it is limiting your profit margin, as well as that it might put some extra pressure on your level depending on its placement in the big picture.
The opposing levels (as far as profit margin is concerned) do not necessarily have to be the strongest, highest probability levels, i.e. the ones which we are looking to trade, but instead they can be any kind of level which has some potential to become an obstacle in your trade. These include weaker levels, which although not suitable for a new low-risk entry they can still cause some trouble, sometimes even just due to professional profit-taking (of previous trades) ahead of a potentially unpredictable area. In the above example the nearest valid opposing level is marked, which indeed created some bounces but not much more mainly due to its incorrect placement in the big picture (not seen here). An experienced Supply and Demand trader (who traded the marked Demand level above) could evaluate and possibly ignore the area marked with an X as it did not contain any valid, strong and fresh (untouched) Supply levels, while the placement in the big picture was not favoring the Supply side either (as seen on higher timeframes). But a trader new to the concept of Supply and Demand should not ignore such areas too easily as they can cause some loss in price direction that can be confusing, as was the case in the above example. Also make sure to check the situation on a higher timeframe in order to be sure that what appears as weak/invalid levels on the smaller timeframe is not actually part of a larger valid level which is only visible clearly on the higher timeframe.
When you have determined how far you can normally expect your trade to run without major issues, then the next and final step is to determine how many pips you have to risk in order to get a good shot at getting the reward. As mentioned previously, the amount you choose to trade is a completely different matter, here we only examine the ratio between the expected reward (distance to opposing level) and the minimum necessary risk (based on the thickness of the traded level). Usually it is relatively easy to determine the minimum necessary risk, which is the distance between your anticipated entry in front of your level, and your stop loss order "hidden" behind your level (there are more details provided elsewhere regarding how to mark your levels and how determine your entry/stop and take-profit prices for your orders).
So let's say your estimated profit margin is 80 pips and the thickness of your level is 20 pips, which would initially suggest that your reward ratio is 4 to 1 (i.e. 80/20). You can expect that in reality this trade will have a reward ratio of about 3 to 1, and in some cases even 2.5 to 1. This is because your orders (as described elsewhere) should never be at the exact price you see on your charts, but should allow some extra space for the market to move. This necessarily translates to a) an entry slightly above the level (or below for Supply levels) and not exactly at its start, b) a stop which allows some extra space behind your level (opposite side), and c) an exit (take profit) order which is safely placed before the expected opposing level. So a trade which on the chart seems to have a reward ratio of 4 to 1 probably has a real reward ratio of 3 to 1 or even less.
A trade which on the chart seems to have a reward ratio of 4 to 1 probably has a real reward ratio of 3 to 1 or even less
But this is not too bad, you can sometimes take trades with a reward ratio as low as 1.5 to 1 depending on your experience. Anything less than that is not recommended even for the more experienced traders, and although we cannot always have ideal setups, it is generally better if you choose trades with a minimum of 2 to 1 reward ratio.
Remember that you cannot extend your target just because you want a better reward ratio, you have to respect any suspected opposing levels. And similarly, you cannot reduce the distance of your stop just to improve the ratio, your stop has to be as protected as possible behind a level and not too close or within the actual level. The only parameter which can be slightly adjusted in your favor (and which improves your reward ratio) is your entry price. This means you might decide to choose a better entry price, but have in mind that this has side-effects: you might miss the proper entry, and thus the expected bounce and/or the new trend depending on the case, and if you do miss the proper entry you might be tempted to enter later during a second return of price to the level, when the level is weaker, invalid, and likely to fail.
As discussed extensively in the next article, being Supply and Demand traders we choose to only trade the first return of the price to the level. It does not matter how much later (hours, days, or even more) price returned to the level, as long as it is the first return of price to the level since its creation (i.e. the level is untouched and considered "fresh" at the moment of entry). So you can try to get a better entry price (especially for trades that would otherwise be discarded just for not meeting only the reward ratio requirement, while meeting the rest of the requirements), but you should be prepared to abandon the level if for any reason you miss the proper entry. It is not always so clear whether you missed the proper entry and thus should abandon the level, or if price will just briefly return to the level once more as part of the same overall move before continuing in the expected direction, as frequently happens. If you are not sure it is safer to abandon the trade and wait for the next opportunity, even if it means you have to wait a day or two to get one.
One last final note is that you shouldn't over-do it when consciously accepting a lower reward ratio for your anticipated trade:
You have to keep in mind that what might be an acceptable profit margin for you, will not necessary be an acceptable reward ratio for other experienced Supply and Demand traders, Institutions, Banks, or any other professional trader.
If they choose not to trade the level because it does not really meet the requirements, then you can surely expect the level to fail without prior notice. It is them who create the vast majority of the trading volume (especially around such areas), so you have to make sure that YOUR decisions are compatible with theirs because obviously it is not going to happen the other way around. If unsure, always discard the level and move on to the next opportunity. Making money in the markets has nothing to do with how often you trade.