# Defining Reward/Risk Ratios With Chart Setups In The Futures Markets

**One of the critical tasks traders face is finding setups** appropriate to their

risk profile and then making a trading plan for each trade. You can useÂ common chart patterns to estimate the

reward and

potential risk of a trade. This will give you a quantitative method for analyzing

whether a given futures trade meets your trade selection criteria.

As most traders know, futures and stocks repeat price movements with

sufficient frequency that the patterns they trace are identifiable, have names

and are tradeable. The fact that price behavior

repeats, allows one to calculate the move a futures isÂ likely to make

once a new pattern setup emerges.Â

The point-value that a futures is likely, or

predicted, to move is called a “measured move.” Research shows that

futures contracts have a high, and statistically significant chance of moving to

the measured objectives in the following pattern setups. The measuring objectives

are conservative for

these pattern setups, but bear

in mind, these are guidelines, not hard-and-fast rules. And of course, honor the

stops.Â

Estimating reward-to-risk ratios is useful because it helps you plan a trade by

determining your entry-point, stop-loss and exit objectives. By establishing your goals for

the trade, you also can determine if the trade provides a suitable return for

your risk tolerance. The reward-to-risk ratio is calculated by taking the price

objective and dividing by the stop (risk), i.e., measuring objective/stop =

reward-to-risk

ratio.Â

My minimum reward-to-risk ratio criteria is 3-to-1.Â

In this lesson, we will look at three common chart patterns: the

head-and-shoulder bottom, the double bottom and the descending triangle.

**Head-And-Shoulders Bottoms**

The calculation of the price objective (reward) and stop (risk) is

straightforward. A long position is entered on the break of the neckline. For

the head-and-shoulders bottom pattern, the measuring objective is twice

the distance from the head to the neckline. The protective stop is placed four ticks below the stop-loss

line and represents the risk. The stop-loss line is created by

drawing a line from the head to the right shoulder.

In the example below in August unleaded gasoline

(

HUQ0 |

Quote |

Chart |

News |

PowerRating), the distance

from the head (.7008) to the neckline (.7765) is .0747, giving a measuring

objective of .8522 (.7765 + .0747). The stop is placed four-ticks below the

stop-loss line at .7655 and is equal to .0100. Hence, the reward-to-risk ratio is

.0747/.0100 or 7.5-to-1, a setup which exceeds my 3-1 ratio minimum. The calculation for a head-and-shoulders top is,

of course, the inverse of a head-and-shoulders bottom.Â

**Double Bottoms**

For double bottoms, the measuring objective is the distance from the bottom of

the double bottom pattern to the resistance level above the double bottoms,

above the “peaks,” if you will. The stop is placed

below the resistance/breakout level and is slightly arbitrary in its

determination. I usually place the stop at a confluence of recent lower highs

and closes below the resistance.Â

In the following setup in September T-bonds

(

USU0 |

Quote |

Chart |

News |

PowerRating), the distance from

the double bottoms (92 20/32) to the “peak” resistance (94 17/32)

is 61 ticks (94 17/32 – 92 20/32), giving a measuring objective of 96 14/32 (94

17/32 + 61/32, or 1 29/32). The stop chosen below the confluence of recent

lower highs

and closes below the resistance (designated by the oblong circle in the chart),

is at 94 5/32, a distance of 12 ticks. Hence, the reward-to-risk ratio is

61-ticks/12-ticks or 5-to-1. Calculations for double tops can be determined

similarly and also apply to triple top and triple bottom setups.Â

**Descending Triangles**

For descending triangles, the measuring objective is twice the* height*

of the triangle, calculated from the high of the pattern to the support, or *base,*

of the geometric figure. The stop is placed above the descending line of the

triangle (the *hypotenuse*).Â Of course these patterns and ratios occur and

can be determined in multiple time frames. The following example is with Nasdaq

100 futures

(

NDU0 |

Quote |

Chart |

News |

PowerRating) using 5-minute bars. This example applies to E-mini

Nasdaq 100 futures as well.

In this example, the distance from the high of the pattern (3810.00) to the base (3750.00)

and breakout point is 60.00 (3810 – 3750), giving a measuring objective of 3690.00 (3750.00 – 60.00). The stop and

risk is above the descending line of the triangle at 3770.0 and is equal to 20.00. The

reward-to-risk ratio here is 60.00/20.00, or 3-to-1. Again, this matches my

reward-to-risk requirement.

Notice in the descending triangle example that the NDU0 did not continue

through to the apex of the triangle. Ideally, the futures will breakdown

approximately two-thirds of the way into the pattern. This results in a higher

likelihood of follow-through to the measuring objective. Here, the NDU0 achieved

the measuring objective by the end of the session and traveled nearly that

distance on the following day.

Using chart patterns to calculate reward-to-risk ratios will assist you in

planning your entry, stop-loss and exit points and will keep you from taking

trades that do not match your trading objectives.

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