How To Master The Art Of Risk vs Reward – R-Multiples Uncovered

 

The Backbone of Performance Measurement

 

I wanted to write this brief but extremely important article about the way I measure trading performance.  Whenever you hear people talking about individual trades they’ve made or lost money on, they very often refer to the percentage gain or loss.

Not me.  I will always record each winning or losing trade in terms of an R-Multiple.  I talk about yearly returns as a percentage of my trading capital but not individual trades.

 

What Is An R-Multiple?

This is not something I created.  It’s a method I learnt from professional trading coach Dr. Van Tharp.  It is a way of measuring trade performance regardless of the price of stock or forex pair etc or even the amount of money won or lost.

For those of you who follow my work, you know that I believe it is absolutely essential to know at least two price points before you enter a trade.

  • Entry Price
  • Stop Loss or the price you will take a loss if the trade goes against you.

The different between these prices is the amount of points risked on the trade.  This is what’s called 1R.

For example: You buy a stock priced at 100p and have a stop loss at 90p.  The amount risked or 1R is 10p.

The idea is that you never lose more than 1R on any trade.  However there will be cases (unless using guaranteed stop losses) that prices may slip through your stop loss and they will exceed 1R although these are rare.

So now you can measure your gains from a winning trade.  Let’s assume the stock goes up to 120p where you exit and take profit.  Your gain can be expressed as an R Multiple, in this case 2R.  Remember 1R was equal to 10p.  On this trade you took profit of 20p so 2R profit.  Note that a 2R gain here was equivalent to a 20% move in the stock’s price because 120-100= 20 points and (20/100)X100 = 20%

 

Let’s look at another example:  This time you buy a stock priced at 500p and have a stop loss at 480p.  So 1R here is 20p.  The stock’s price increases to 540p and you take profit.  You have taken 40p profit or 2R profit.  Same as the last trade.  But note this time that the percentage increase in the stock’s price is quite different.  540-500=40 and (40/500)X100 = 8%

I would have made the same amount of money on each trade even though the percentage increases were quite different.  This is because I keep 1R a consistent money amount, for example 1R could equal 1% of my trading account.

 

Trade Expectancy

For each individual trading strategy I am trading, I will know the expectancy of every trade.  Note that if this number is a negative, then you’re losing money!

If we looked at the results of 100 trades using the same strategy we will have a long string of winners and losers.  The amount of winners vs the amount of losers is the win rate, usually expressed as a percentage.

In addition to that we can calculate the expectancy of the strategy.  This is done by adding all the winners and subtracting the losers and then dividing by the number of trades.  For example:

  • Total 100 trades
  • Total of winning trades = 120 R
  • Total of losing trades = 35 R
  • Trade expectancy = (120-35)/100 = 0.85R

What this means is for every trade we make according to the rules of the strategy it is worth 0.8R.  So if we made 10 trades in a month, we should profit an average of 0.8 X 10 = 8R per month.

Remember I keep the money value a constant for each strategy for example 1% of my account = 1R

So in the example above, after those ten trades, I should average an 8% gain in my trading account.

 

But That’s Not All..

I have given you a pretty good overview of why and how I use R-Multiples to measure a strategy’s performance.  However, Expectancy is not the only factor to take into account when looking at performance.

Additionally there are factors of Opportunity, R-Multiple distribution and Drawdown to take into account but these will be discussed in other articles.

 

So I hope you too can see the value of using R-Multiples.  Why not try them out if you aren’t already using them.  Go over you past trading records (you really must have records!) and work out the risk on each trade and then the amount gained or lost expressed as an R-Multiple.

I you would like to discuss this further or have any questions about R-Multiples then please leave comments down below or email me at jarrod@thetransparenttrader.com

 

Jarrod

 

Featured image by takomabibelot via Flickr.com

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