These is one of the key trading lessons that really helped me understand risk management long ago. This is one of the keys to successful trading, viewing risk as your metric for trading.

This article was originally published on the Van Tharp Institute’s Web Site.

Risk and R-Multiples

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 ~Mel

Van says that risk is the amount of money you are WILLING TO LOSE if you are wrong about the market. So his definition of risk 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 that you have 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 that 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 either a percentage, in points or in dollar terms. For example, William O’Neil says that when you buy a stock, you should get out when it loses 7-8%.  Another trader proposes a philosophy of getting out of a stock when it moves 1-2 points against you.

Tell me more about stops.

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, thus giving you a profit-taking exit as well.

For example, if you buy a stock at $30, and have a 25% stop, then you would exit the trade if the price drops 25% to $22.50.

In a trailing stop example: 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 $45.00 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. BUT 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.

As an 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.  However, if you had used a buy and hold philosophy, the same stock hit a low of $1.58 in October 2002.  You might never get back to breakeven (an 800% gain from current prices) in your lifetime, but the stop would have totally allowed you to avoid that fall.  In addition, it would have gotten you out of stocks like Enron and WorldCom before any of them 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.

Tell me more about Risk or (R).

Risk to most people seems to be an indefinable fear-based term. It is often equated with the probability of losing, or others might think being involved in futures or options is “risky.” Van’s definition is quite different to what many people think.

As far as Van is concerned, risk is definable.

Many people in the investment world are overly optimistic about the trades that they make. They don’t understand their worst case risk or even think about such factors.

Instead, people are seduced by trading terms such as “options” “arbitrage” and “naked puts,” Or, they buy into the academic definitions of risk such as volatility, which make for good theoretical articles by academicians, but they totally ignore two of the most significant factors in success. The golden rules of trading…

Never open a position in the market without knowing exactly where you will exit that position.

And

Cut your losses short and let your profits run.

So let’s look at the first golden rule in much more detail to be sure that you understand it.  That rule is to always have an exit point when you enter a position.  The purpose of that exit point is to help you preserve your trading/investing capital.  And that exit point defines your initial risk (1R) in a trade.

Let’s look at some examples.

Example 1:

You buy a stock at $50 and decide to sell it if it drops to $40.  What’s your initial risk?

The initial risk is $10 per share.  So in this case, 1R is equal to $10.

Example 2:

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?

In the second example, your initial risk is $2 per share, so 1R is equal to $2.

Example 3:

You want to do a foreign exchange trade, buying the dollar against the euro.

Let’s say that one hundred dollars 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. R is simply the initial risk per share of stock or per futures contract or per minimum investment unit.

However, it’s not your total risk in the position because you might have multiple units.

What’s my total risk?

Your total risk would be based on your position sizing and how many shares or contracts that you actually buy.

For example, you may buy 100 of the shares in Example 1,  which would be 100 multiplied by the share cost of $50 each. So your total COST would be $5000. But you are only willing to risk $10 per share. So $10 multiplied by 100 shares = $1000 total risk for this position.

In example 2,  you also buy 100 shares at the $50 price for a total COST of $5000. However, in this scenario you are going to get out if it reaches $48. So your risk is $2 per share multiplied by the 100 shares – you are only risking $200 of your $5000 investment.

Understanding R-multiples

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.  That means if you say you’ll get out of a stock when it drops $50 to $40, then you actually GET OUT when it drops to $40.  If you get out when it drops to $30, then your loss is much bigger than 1R.

It’s twice what you were planning to lose or a 2R loss.  And you want to avoid that possibility at all costs.

You want your profits to ideally be much bigger than 1R.  For example, you 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.  You now make a profit of $20 per share.  Since this is 10 times what you were planning to risk we call it 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?

Answers

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% draw downs.

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. And what could be better than that?