Risk and R-Multiples
To most people, "risk" is an indefinable, fear-based term, usually equated with the probability of losing. Some, for instance, might think that being involved in futures or options is “risky.”
Van’s definition of "risk," however, is quite different.
Knowing when you’re going to exit a trade is the only way to determine how much you’re really risking in any given trade or investment. If you don’t know when you’re getting out, then, in effect, you’re risking 100% of your money.
|Risk and R-Multiples|
Van says that risk is the amount of money you are WILLING TO LOSE if you are wrong about the market. More specifically, it is how much you’ll lose per unit of your investment (i.e., share of stock or number of futures contracts) if you are wrong about the position you've taken.
This is called the initial Risk, or (R) for short.
One of the key principles for both trading and investing success is to always have an exit point when you enter a position. Trading without a pre-determined exit point is like driving across town and not stopping for red lights—you might get away with it a few times but sooner or later something nasty will happen.
In fact, the exit point you have when you enter into a position is the whole basis for determining your risk, R, and the R-multiples (i.e., risk/reward ratios) of your profits and losses.
Your exit point can be defined in terms of points, dollars or a percentage. For example, William O’Neil says that when you buy a stock, you should get out when it loses 7-8%, while another trader proposes getting out of a stock when it moves 1-2 points against you.
A stop is basically a preplanned exit. Van says that having stops prevents disaster, even though this strongly goes against the grain of the long-term buy-and-hold philosophy.
When the price hits your stop point, you exit the market. A trailing stop basically adjusts that stop when the market moves in your favor, giving you a profit-taking exit as well.
For example, if you buy a stock at $30 and have a 25% stop, you would exit the trade if the price drops 25% to $22.50.
Here's a trailing stop example: Let's say you buy the same stock at $30 (with the initial stop at $22.50), but if the stock moves up to $60, your 25% trailing stop would also move up with it and would be placed at 25% of $60, which is $45.
In other words, you would get out of the trade if the stock turned and dropped to $45, but because you bought it at $30, you would have locked in half your profit, or $15. The trailing stop, in other words, moves the exit point in your favor as the price moves in your favor. However, you must NEVER move it backwards. Thus, if your stock moves down from $60 to $50, you would still keep your exit at $45, 25% away from the high of $60.
In Van’s opinion, this kind of stop is a safe form of buy-and-hold. You could be in a stock for a long time, but if something fundamental changes, it gets you out.
Let's use a real-world example. JDSU went from about $12 in February 1999 to a high of nearly $150 in 2000 (prices are adjusted for a number of share splits). A 25% stop would have kept you in the entire move. You would have been stopped out in April of 2000 at a substantial profit. If, on the other hand, you'd used a buy-and-hold philosophy, you would have suffered severe losses when, in October of 2002, the same stock hit a low of $1.58. To break even, the stock would have to rise 800% from current prices, something it may never do in your lifetime. A stop would have totally allowed you to avoid that fall, along with those of other stocks like Enron and WorldCom before they became headlines.
There are many reasons for using tighter stops, and you will probably need to use them for a variety of different trading styles. We are simply suggesting 25% stops as a substitute for the “buy-and-hold” philosophy.
We are not going to get any further into stops at this point because we want to get back to talking about risk. Just remember, you need to know when you are getting out of a position (your exit point or stop) to determine your risk.
To most people, risk seems to be an indefinable fear-based term that is often equated with the probability of losing; for example, they might think that being involved in futures or options is “risky," or they may be overly optimistic about the trades they make because they don’t understand their worst-case risk or even think about such factors. Instead, they're seduced by trading terms like “options,” “arbitrage” and “naked puts,” or they buy into the academic definitions of risk like volatility, which make for good theoretical articles by academicians, but totally ignore two of the most significant factors of success, the "Golden Rules of Trading":
Never open a position in the market without knowing exactly where you will exit that position,
cut your losses short and let your profits run.
Let’s look at the first golden rule in much more detail to be sure that you understand it. It says that you must always have an exit point when you enter a position. The purpose of the exit point is to help you preserve your trading/investing capital. It defines your initial risk (1R) in a trade.
Let’s look at some examples.
You buy a stock at $50 and decide to sell it if it drops to $40. What’s your initial risk?
Your initial risk is $10 per share, so in this case, 1R is equal to $10.
You buy the same stock at $50, but decide that you are wrong about the trade if it drops to $48. At $48, you’ll get out. What’s your initial risk?
Your initial risk is $2 per share, so 1R is equal to $2.
You want to execute a foreign exchange trade, buying the dollar against the euro. Let’s say that $100 is equal to 77 euros. The minimum unit you must invest is $10,000. You are going to sell if your investment drops down by $1000. What’s your risk? What’s 1R?
We made this example sound complex, but it isn’t. If your minimum investment is $10,000 and you’d sell if it dropped $1000 to $9000, then your initial risk is $1000, and 1R is $1000.
Are you beginning to understand? R represents your initial risk per unit. It is simply the initial risk per share of stock, or futures contract, or minimum investment unit. Keep in mind, though, that it isn't your total risk in the position, because you might have multiple units.
Your total risk would be based on your position sizing and how many shares or contracts you actually buy.
Let's say you bought 100 of the shares in Example 1, which would be 100 multiplied by the share cost of $50 each, giving you a total COST of $5000. However, you are only willing to risk $10 per share, so $10 multiplied by 100 shares = $1000 total risk for this position.
If you bought 100 of the shares in Example 2 at $50 each, your total COST would be $5000, but because you plan on getting out if the stock drops to $48, your total risk is $2 per share multiplied by 100 shares. In other words, you'll only be risking $200 of your $5000 investment.
The next key point for you to understand is that all of your profits and losses should be related to your initial risk. You want your losses to be 1R or less—which means that if you say you’ll get out of a stock when it drops from $50 to $40, you actually GET OUT when it drops to $40. If you get out when it drops to $30, your loss is much bigger than 1R. It’s twice what you were planning to lose, or 2R. You want to avoid that possibility at all costs.
Instead, you want your profits to be much bigger than 1R. For example, you could buy a stock at $8 and plan to get out if it drops to $6, so that your initial 1R loss is $2 per share. If you go on to make a profit of $20 per share, you've made 10 times what you were planning to risk—in other words, you've made a 10R profit.
You try it:
1. You buy a stock at $40 with a planned exit at $35. You sell it at $50. What’s your profit as an R-multiple?
2. You buy a stock at $60 and plan to get out if it drops to $55. However, when it goes that low, you don’t sell. Instead, you just stop looking at it and hope it will go
back up. It doesn’t. It becomes part of the headline business news involving corporate scandal and eventually the stock becomes worthless. What’s your loss as an R-multiple?
3. You buy a stock at $50 and plan to sell it if it drops to $49. However, the stock takes off and jumps $20 in three weeks when you sell it. What is your profit as an R-multiple?
1. A 1R loss is $5. Your profit per share is $10, so you have a 2R profit.
2. A 1R loss is $5. Your loss per share is $60, so you have a 12R loss. Hopefully, you can understand why you never want to let this happen.
3. A 1R loss is $1. You profit per share is $20, so you have a 20R profit. And hopefully, you understand why you want this to happen all the time.
What's really interesting is that once you understand risk and portfolio management, you can design a trading system with almost any level of performance. For example, you can design a system to trade for clients that would make about 30% per year with only 10% drawdowns.
On the other hand, if you want to trade your own account and be a little more risky, you can design a system that will produce a triple-digit rate of return as long as you have enough money to do so and are willing to tolerate tremendous drawdowns.
It’s a whole new way of thinking for some, but most successful traders think in terms of risk/reward, which, of course, gives them an edge out there in the markets. Learning to trade and invest in this way will keep you in the game longer and enable you to run with your profits and cut your losses short. What could be better than that?
A Good Introduction Course For This Topic:
Introduction to Position Sizing E-learning Course
How do you decide how much you should risk on your next trade?
Risk too much and you could blow up your account. Risk too little and a big win won’t even pay for your dinner.
Dr. Tharp’s Introduction to Position Sizing™ Strategies Course includes audio-visual and interactive learning activities that explain this complicated subject in clear, easy-to-understand terms. You will learn the basics of position sizing strategies and the dramatic difference they can make in your results.
Because the course is an introduction to position sizing strategies, it covers basic material and offers a great start to the process of understanding and utilizing the concepts and includes material on understanding expectancy, including examples.
The book The Definite Guide to Positing Sizing covers very extensive material and goes into technical depth in many areas. As its name implies, it is indeed quite definitive. However, some people find position sizing strategies to be a complicated topic and have a hard time grasping and applying the ideas from the book, so we developed this e-course for two primary groups of people: auditory/visual learners who learn more effectively from an instructional format full of interactive features, and those who aren't really interested in the deeper technical aspects of position sizing strategies but realize that an introduction to the topic would still help their trading.
This course is perfect for busy professionals who need a practical way to understand risk and how to keep losses to a minimum.
We see a natural course of study starting with the e-course and then moving up to the Definitive Guide.
You will also learn a lot about positing sizing when you play the Positing Sizing Trading Simulation Game. The first three levels are free!
The Rest of The Tharp Think Concepts:
Psychology of Trading
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