Fib Recycling…

In an earlier post, I explained my simple three line system for assessing the risk reward ratio of a trade before it is taken.  However the problem with that approach is that you need to perform some quick mental calculations to 1) assess the risk by calculating the difference between the expected entry price and the stop, and 2) assess the profit target by multiplying the risk by two (or whatever your required risk/reward ratio is) and adding it (for longs) or subtracting it (for shorts) from the expected entry price.  In the heat of battle, these calculations may seem a bit overwhelming, which either results in the trader missing the best possible entry because he/she is busy making those assessments, or more realistically the trader will enter the trade without performing this assessment to realize within a few seconds that the trade shouldn’t have been taken.

So here is an even simpler solution to this problem that doesn’t even require any mental calculations.  The solution is based on custom settings of the Tradestation’s Fibonacci Price Retracement Lines tool that is part of the drawing toolbar.

By using the settings above and by plotting the retracement lines from the expected entry price to the last pivot (assuming that you base your risk on pivots), the tool will automatically plot a 300% retracement which in this case is synonymous with a 2:1 risk/reward ratio.

Above you see that if I expect to enter this short trade around 766.50, with a stop slightly above the last pivot high at 767.50, then my reward (assuming a minimum requirement of 2:1) should be at least 764.25.  In this example you see that this reward would be outside my Keltner Channel and is therefore a bit less probable.  So I would most likely have to wait for a pullback (higher price) to reduce the risk and at the same time reduce the minimum required reward to stay within the channel.