Why Traders Erroneously Assess Risk/Reward -- Plus Extended Fifths, and the Moment of Truth

Friday saw the rally continue, and there's not much to add in that regard, so today's update is going to focus on a couple of (hopefully) educational things which go beyond the charts of the moment.

To lead into the first of those, I'm going to refer back (once more) to something I wrote on February 10:

There is only one thing bothering me for bears here, and that's the fact that my preferred count has us presently retracing an extended fifth.  Extended fifths frequently form impressive "double" retrace patterns -- if that happens here, the current rally will retest the all-time high before dropping to new lows.

Today I'd like to share a chart example of a double-retrace, so readers can understand why (despite all the bullish signals) I've continued giving the bear count airtime.  Below is a Forex chart of US dollar/Japanese yen, and it shows an extended fifth wave (in this case, an extended fifth wave to the downside), followed by a complex double retrace.

We can see the first leg of the rally retraced back up to roughly 101.400 -- from there, the bottom was retested (and broken slightly) before the second leg of the retrace formed, to new highs.  We can also see that the retest of the low was faster and seemingly more powerful than the first leg of the rally.  We can also extrapolate that a number of traders were whipsawed at that double bottom -- which then helped provide fuel for that second leg up.

The potential of a similar chart pattern on the S&P 500 (SPX) is literally the only thing that's kept me from committing whole hog to the bull case.  My main regret for readers is that I didn't immediately focus on the fact that a retest of the high was reasonable and probably even likely (I regret it because, early on, I did give strong consideration to going that route publicly).  Considering the strength and speed of this rally, pretty much any call since February 5 that even entertained notions of selling turned out to be the wrong call.

(Here I should insert a segue to the next topic, but I don't have one -- so this sentence serves as the segue!)

There are many ways to approach trades, but let's quickly discuss two of those ways:  One approach is what I refer to as "confirmation trading" -- an example of confirmation trading would be shorting a breakdown of a head and shoulders pattern.  The pattern breakdown in essence "confirms" the trade, and suggests the direction of the market.

Another approach, and one that's loaded with pitfalls for new traders, is to try and be a bit ahead of the market.  I utilize both approaches, depending on what the market gives me, but use the second approach when my wave counts support action against a resistance/support level, and the next two criteria are also met:

1.  There are clear ways to mitigate risk via stop levels.
2.  The reward is significant vs. the risk.

The most recent real-life example of this second approach would be February 5:  The wave counts suggested a fifth wave bottom was potentially at hand, and there was a nearby support zone which could function as a stop level.  In that update, I both specifically warned newer traders against front-running, and also suggested experienced traders might take a crack at it, as long as they approached with extreme caution.  So why did I warn off inexperienced traders?

The front-running technique tends to be harder for new traders, for several reasons:

1.  Many have a difficult time letting go of losing trades.  (Some trading wisdom from the movie Rounders: "Throw away your cards the moment you know they can't win.")
2.  Many tend to let go of winning trades too quickly.
3.  Many tend to erroneously assess risk/reward -- both theoretically and practically.

The third tendency can stand alone in the theoretical sense; but in the practical sense, it's frequently the result of the first and second tendencies combining.  Many newer traders consistently under-assess their actual risk -- since they hold onto losing trades longer than they "know" they should, the true risk is actually higher than it looks on paper.  At the same time, they frequently over-assess their reward -- since they let go of the winners too quickly, the intended reward goes unrealized.

For example, if I take a trade thinking I'm risking 5 points to potentially make 50 (an excellent 1:10 risk/reward ratio), but instead exit after I make 5 points (due to anxiety or otherwise), then my risk/reward wasn't really 1:10, it was 1:1.  And on the other hand (when that trade goes bad), if I fail to honor my 5 point stop and don't actually exit until I've lost 10 points, then my risk/reward is, in practice, nowhere near my intended 1:10 -- it is, in reality, an abysmal 2:1 (risking 10 points to make 5). 


As Yogi Berra once said, "In theory, there's no difference between theory and practice, but in practice, there is."

If you're a new trader who's struggling with the usual "Why isn't anything working?" this might be one area to examine.

My point is that trying to front-run turns (in either direction) only works if one has a system for it, and then remains consistent and disciplined -- and often those are skills new traders struggle with.

Moving on to the charts:  Before I address the current SPX chart, I do need to mention that the Russell 2000 (RUT) broke through its apparent pivot zone (as discussed previously) which thus creates a potential thorn in the bear counts.  While I remain skeptical of the sustainability of this rally, outside of the discussed double-retrace, there is nothing in the charts that's actually bearish at the moment (one reason for my earlier discussion on front-running -- do with that what you will).  To the contrary, SPX has powered through every resistance zone it's encountered so far, and is now staring down the important zone: intermediate resistance at the all-time high.
  

On the SPY chart, there's some additional discussion of the (B) wave potential.  While there is (unfortunately) no hard and fast invalidation level for a (B) wave, there is still common sense.

In conclusion, in Friday's update, I discussed some of the more bullish options and potential targets, and nothing has changed in that regard.  SPX is into the zone where it's time for bears to make a stand if the ABC count holds any water.  So it's time for patience at the moment of truth -- but looking down the road, in the event bears can't get it done here, then we'll be wise to put away the bear claws until such time as the next bearish signals arrive from the market.  Trade safe.

Follow me on Twitter while I try to figure out exactly how to make practical use of Twitter:
 @PretzelLogic

Reprinted by permission; Copyright 2014 Minyanville Media, Inc.