The Pro Trader's Checklist: Define Risk

In this series so far, we have discussed how to define a fair price and fair value area, as well as how to recognize when trend potential is high and momentum apt to kick in.

Defining risk is one of the most difficult and immediate tasks a trader must do after entering a position. When entering a trade, one has a bullish or bearish bias. Risk is thought to be a change in momentum. If a short position is taken due to bearish read on momentum, that trade should be held until momentum turns positive. Conversely, a long position should work until momentum turns negative.

To define risk, first determine the high-volume or fair price to establish a fair value area. To determine a high-volume price, I prefer to use a bell curve. With this device, we can track range (vertical dimension or high minus low) as well as time at price (horizontal dimension). The macrograph below displays daily price action using time and price. Each shape displays the high-volume price. It is that price that sticks out the furthest to the right. This is the first step in identifying a fair value area. Once a fair price is identified, we can construct a fair value area. A value area covers one standard deviation of volume around the mean or high-volume price. Fair value areas are integral when defining risk.

As a market rises the value area low can be used to define risk and as a market falls the value area high is used to define risk. This point is illustrated in the second chart. Using value areas tops and bottoms is a good way to lock in profits during a trending market. Risk is a change in momentum and a violation of a value signals that change.

John Seguin, Market Mentor Mentoring

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