Today’s Market Maven is brought to you by the letter ‘R’.
It’s a letter that raises strong opinions and hot debates among traders.
The ‘R’ stands for risk. And you should know if your ‘R number’ is 0.5… 1… 3 or whatever…
In a moment I’ll show you how to calculate yours – and what to do with that information. But first, I feel that I should put the other side of the case…
The anti-R camp
There are people out there who disapprove of ‘R’.
They say that an ‘R number’ gives you no real information about profitability (that’s true that a good ‘R’ on its own won’t guarantee profitability, but it doesn’t mean that ‘R’ doesn’t have its uses).
They say that ‘R’ is meaningless – they just want to see the profit and loss figures in pounds and pence.
I completely disagree with this – and I’d like to show you why.
Calculating your ‘R’
As I said before, ‘R’ stands for risk. And your ‘R multiple’ is your risk-reward ratio – i.e. how much your reward on a trade is compared to how much you risk.
So, if you’ve risked £100 to make £200, then your R value is 2. If you’ve risked £100 to make £50, then your R multiple is 0.5.
As long as you’re keeping a good trading log, you should also be able to calculate your average R multiple, from your average win size, compared to your average loss size.
The great thing about R multiples is that it allows you to easily see how your trades are measuring up, without getting distracted by pound signs.
So, if I know the R multiple that I’m aiming for, and I see a trade that’s fallen below this – I can quickly spot a duff.
Compare this to using the profit and loss figures – here you may have staked lower on one trade because you’d reduced risk following a losing run… Or you’ve staked higher because your trading fund has increased… These will affect your P&L figure, and can affect how you feel about that trade.
The R multiple, however, takes that emotion out of it.
So, what should your R multiple be?
Traders often talk about only taking trades with an R multiple of 2 or more. So, if they’re risking £50, they expect to make at least £100. It feels nice and comfortable – and you don’t need to be right that often to turn a profit.
Trades with a high R number are difficult to win.
Consider at set-up with a distance of 10 points to your stop loss, and 20 points to your profit target. Small wobbles in the market are going to knock that trade out more often that not – even if you’ve got your technicals right. And the same is true if you scale that trade up to a longer timeframe.
I frequently hear traders bragging about high R multiples – and berating anyone who trades with an R multiple of less than 1.
There’s definitely some middle ground to be found here. If your R multiple is too high, you’re going to struggle to win enough trades. If your R multiple is too low, the occasional loss or two will set you badly off track.
And R multiple may tell you a lot more than a P&L figure, but it can’t give a picture of profitability on its own. It must be balanced with a suitable success rate.
If you’ve an R multiple of 4, and a win rate of 25% – you’ll be profitable.
But with such a low win rate, your losing runs are likely to be immense, so you could suffer from seriously bleak periods of trading.
Can you and your trading fund take that?
If you’ve an R multiple of 0.25, and a win rate of 85%, you’ll be profitable.
But it’ll take 5 winners to bring every losing trade back into profit – this kind of trading can feel like an uphill struggle.
Personally, I favour trading with a lower R multiple, and don’t hold with the rule that all trades should have a 2:1 profile.
Find an R multiple that works for you – and track your trading according to it.
If you’re dipping below your optimum – look for where you’re going wrong.
If you’re improving on your R multiple – check that your success rate isn’t suffering as a result.
If your success rate and your R multiple are both in good health – you should give yourself a pat on the back!