Risk-Reward Ratio From Vertical Counts On 3-Box Charts
The risk-reward ratio is the ratio of the potential gain from any trade, derived from the Point and Figure count, to the possible loss if the trade goes wrong and the price goes in the opposite direction, derived from Point and Figure double-top and double-bottom signals.
Risk-reward ratio from vertical counts on 3-box charts
There are two stages to the vertical count –first is the establishment and next is the activation. The risk-reward ratio can only be computed once the count has been established and the activation column is in the process of being built.
The above figure shows a typical bottom.
After the first column of Xs in column 2 off the low, the establishment stage takes place when the length of the column of Xs is fixed by the reversal of a column of 0s in column 3.
At this stage the vertical target can be established and the reward calculated.
The reward is the difference between the vertical target and the price at the breakout above the highest X in the counting column of Xs.
The length of the correction column of 0s in column 3 is fixed by a reversal of a column of Xs in column 4.
At this stage, the risk may be calculated.
The risk is the difference between the price at the breakout above the highest X in the counting column - above the blue line - and the value of the 0 below the correction column of 0s - below the red line.
The calculation is as follows: The vertical target is the number of Xs in column 2 multiplied by the box size, multiplied by the reversal, added to the low in column 1.
Vertical target = (7 x 1 x 3) + 20 = 41
The reward is the vertical target minus the price at the double-top breakout above the blue line, marked A. Reward = 41 - 28 = 13
The risk is the price at the double-top breakout minus the price at which the first double bottom sell would appear on the chart if the price went against the trade - below the red marked B. Risk 1 = 28 - 22 = 6
Risk-reward ratio 1 = Reward/Risk = 1 3/6 = 2. 17
A good risk-reward ratio is around 3 or greater. Short-term traders will accept lower risk-reward ratios that are sufficiently greater than, say, 1.0 to 1.5.
Risk-reward ratio from horizontal counts on 3-box charts
The problem with horizontal counts is not the reward but the risk, because the exit from the pattern can be quite complex.
Although we always put the stop below the lowest low in the pattern, this results in increased risk levels.
It is, therefore, best to study the pattern and determine subjectively where your stop should be placed.
Calculating risk-reward ratios from 3-box horizontal counts
Risk level 1 is the price at which the first double-bottom sell wouldappear on the chart if the price went against the trade (below the red line, marked B), whereas risk level 2 is the row below the low of the pattern, marked C.
The horizontal target = (8 x 1 x 3) + 19 = 43 The breakout row is at 25, marked A.
The reward = 43 - 25 = 18
Risk 1 = 25 - 20 = 5
Risk 2 = 25 - 18 = 7
Risk-reward ratio 1 = 1 8/5 = 3.60 Risk-reward ratio 2 = 1 817 = 2.57
You therefore have two risk-reward ratios to work with and may allocate your trade accordingly.
Normally, however, the low of the whole pattern would be the greatest risk level.