This is the second portion of a 2-part article explains 'support' and 'resistance' with layman terms and then tells the reader how risk and reward can be defined.

Risk and reward management

Good traders are mindful of risk management all the time. Minimize your risk and you get to stay in the game longer. The longer you can stay, the greater the opportunities to make money.

Lets consider the following risk management rules:

1. Prices move up and down; it is as likely to move one way or another - do not presume to know its direction
2. Resistance and support stays until broken - do not presume to know that they will break
3. Therefore the best bet is to buy low sell high - buy near resistance and sell near support
4. Place stops
5. Always aim for a better than 1 reward-risk ratio

Lets come back to our example of resistance at 1 dollar and support at 90 cents. By considering our risk management rules, we trade Stock X between 90 cents and 1 dollar. Of course if price goes beyond 1 dollar after we buy we will be very happy. But we must first make sure that we will still make money if price can only make it to 1 dollar. Next we protect ourselves buy placing a stop at 89 cents to protect ourselves just-in-case. The only thing left to do is to buy as near to 90 cents and sell at 1 dollar.

Lets look at the following table:

As can be seen from the information above, buying Stock X requires planning and patience. The further away from the support, the quality of reward diminishes and risk increases. At 95 cents, it does not seem worthwhile to buy anymore because te reward just does not pay off the risk if the decision turns out to be wrong.

Note: The example above does not take transaction costs into account. If transactions costs were included, a decent entry price is lower than 95 cents. In addition, adjusting the stop price and target or 'sell at' price will change the risk and reward accordingly. 

Mentioned in the beginning of this article, resistance and support is a crucial concept. Knowledge of resistance and support can help us understand the ebb and flow of price and plan our entry-exit as well as reward-risk.

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Resistance and support is taught in course Paper And Pencil Series: Practical Technical Analysis (For Novices). 39 Intakes have been conducted for close to 800 students. Not knowing resistance and support is a competitive disadvantage.

For more information, contact 6492 3196 for assistance.