risk-reward-ratio

One of the most effective ways to identify a turning point in the market is to use divergence signals.

 Divergence signals can help you identify whether the market is likely to reverse when it reaches a support or resistance level.

 The way to identify divergence in the market is with the use of oscillating indicators, such as the RSI, which is one of the most popular and widely used indicators.

 But you don’t use RSI divergence alone; you use it as one of the confluence factors in this strategy.

Before we discuss all the factors you need in this strategy, you first need to know what divergence is.

Divergence simply means that the market and the indicator are out of phase.

That is, the price waves and the indicator movement are not synchronized — the price may be making a higher high when the indicator is making a lower high. 

 There are a lot of traders who use the RSI divergence as a strategy to trade the market, and they are doing well.

However, in my trading strategy, we will use it only as one of the multiple confluence factors to get high-probability trade setups.

 To use the divergence as one of the confluence factors in this strategy, we have to identify a clear doji bank breakout trap first because that’s what we are trading.

Once we have all the criteria for our doji bank breakout trap, we can then plot the RSI indicator to see if it supports our trading decision. 

 Let me give you an example with this AUD/USD H4 chart below:

trading-a-doji-with-divergence

As you can see in the chart, the market is moving horizontally between support and resistance level.

A doji candlestick pattern forms at the resistance level, creating a clear bank breakout trap. So, we have a good signal, but we need to evaluate the risk-to-reward ratio.

Look at the chart below:

doji-with-risk-to-reward-ratio

Evaluating the risk-to-reward ratio, we can see that this trade opportunity offers at least a 5:1 reward/risk ratio.

This is very interesting because if we take this trade and the market goes in our favor, we will need to lose five trades in a row to lose all the money we got from this trade.

Can you see why evaluating the risk-to-reward ratio is important and should be taken into consideration?

Now that we have established that the trade is worth the risk, we can use the RSI indicator to see if there is some divergence between price and the RSI, which will give us additional confirmation to take this trade.

Look at the same chart below:

trading-the-doji-candlestick-pattern

As you can see, there is a clear divergence between the price and the indicator, which indicates a potential reversal. 

This confluence of multiple factors (trade signals) gives us more confidence in our trade.

This confidence is very important, as most traders can’t pull the trigger when they find opportunities because they don’t have solid reasons to take the trade. 

Having a confluence of multiple factors will convince you to enter a trade because you know that not only is there the bank breakout trap in the market but also a clear divergence, which supports the signal and reinforces your trading decision. 

Look at what happened next:

doji-as-a-trading-signal

As you can see, after the doji bank breakout trap formed and the RSI showed a bearish divergence, the price fell, reaching the support level.

To take this trade, you only need to place a sell order at the close of the doji and put a stop loss above the upper shadow and the profit target above the next support level.

Let me give you an example to help you understand how we can combine the RSI with the doji bank breakout trap to have a confluence of multiple signals for a trade setup. 

Look at the chart below:

trading-with-the-doji-pattern

This is a EUR/AUD H1 chart, and as you can see, the market is ranging. In other words, it is moving between support and resistance.

We have spotted a nice doji candlestick (which usually implies a pause in the market) that formed a clear bank breakout trap.

So, right now, we have three important elements:

  • A ranging market 
  • A doji candlestick at the resistance level
  • A bank breakout trap (false breakout).    

Now, we need to calculate the reward-to-risk ratio to see if the trade offers a good reward or not.

See the chart below:

risk-reward-ratio

As you can see, by evaluating the reward-to-risk ratio, we can see that this trading opportunity provides us with more than the 8:1 reward/risk ratio. 

That is, for any $1 we risk, we stand to gain $8.

I always insist that we take only trades that offer at least a 2:1 reward/risk ratio because what will make us winners, in the long run, is our money management.

With a 2:1 reward/risk ratio, we can still be profitable even if we lose 6 out of 10 trades. I’ll explain this to you in the following lessons.

Now that we have established that the trade offers a good reward/risk ratio, we go ahead to check whether there is a divergence between price and the RSI indicator — a divergence supports the bank breakout trap signal and convinces us to take the trade.

Look at the chart when RSI is attached:

Look at the chart below:

trading-with-the-doji

As you can see, there is clearly a divergence between price (it’s making a higher high) and the RSI indicator (it’s making a lower high).

This divergence signals a potential price reversal.

So, we have all elements we need to be convinced of the trade: a ranging market, a doji that formed at the resistance level and created a false breakout (bank breakout trap), an interesting reward/risk ratio, and finally, an RSI divergence.

So, we can now take this trade and be 98% sure that the market will go in our favor because we have solid reasons behind our trading decision.

To take this trade, we simply place a sell order at the close of the doji and put our stop loss above the upper shadow and our profit target above the next major support level.

Look at the chart below to see what happened next:

doji-candlestick-pattern-trading

As you can see in the chart, after the formation of the bank breakout trap (with the RSI showing a divergence),the market went down and reached the support level.

Trading the doji bank breakout trap in combination with the RSI divergence is easy and profitable.

But it does not happen every time. So, if you don’t find a divergence, you can simply plot the Bollinger band to see if the doji is rejected from the upper or the lower band.

Sometimes, you will find a doji bank breakout trap with a good reward/risk ratio, but there is no divergence of the RSI and no rejection from the Bollinger bands. 

This should not stop you from taking the trade since the confluence factor we are looking for only offers additional confirmation that supports our trading decision; it is not the most important thing.


Conclusion

In this post, we have shown you how to combine the doji bank breakout trap pattern with RSI divergence to get high-probability trades.

You can learn more of such strategies from our free Telegram channel where we interact and share more knowledge. I also give out 2 to 3 live Forex signals per week for free.

 

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