What is R?
Any sound trading methodology has to incorporate risk management, and one of the easiest ways to do that, is to use the “R” method.
“R” is a fixed dollar amount that stands for both risk and reward, and is best arrived at by using a percentage of your total trading capital. It allows you to size your position in relation to your risk level instead of in an arbitrary way. For example, if you have $50,000 available in trading capital (cash not including margin), you might use one quarter of one percent (.0025), or $125.00, as your “R” factor. This is the total amount you are willing to risk per trade and is expressed as 1R.
In the example below, A is a former support level that was broken, and now is a potential resistance level. Price has been trapped between B and C level, and you are looking to go long if it breaks back above B. You know that a reasonable stop loss would be just below level C, so you determine the price distance between you entry just above B and your stop just below C. Let’s say that this distance is 50 cents. You now take that distance and divide it by your “R” factor, which gives you a position size of 250 shares ($125.00 / .50 = 250).
You now know that if your trade fails and hits your stop-loss order, the most you can lose is $125.00 or 1R. The goal then becomes to only take trades where you have the best potential reward for your 1R risk, ideally 1:3. In this same example, the resistance level of A is a reasonable target for a successful trade, so you determine the distance between your entry just above B, to the target of A. You then divide this number by your “R” factor to see if the trade is worth taking. If the distance between A and B is $1.50 then you have a 1:3 risk/reward ratio and the trade is a good bet ($1.50 / .50 = 3).
The higher the risk/reward ratio you have on your trades, the fewer times you have to be right, and still make money, as this chart below illustrates.
|Risk||Reward||# of Trades||50% WT||40% WT||30% WT||20% WT|
|WT =Winning Trades|
You can see that if you only take trades that have a 1:3 risk/reward ratio, and you are correct just 50% of the time, you will have a 10R profit on ten trades.
Understanding how to use risk/return and position sizing allows you to make sure you are never over extended on a trade and allows you to always return to fight another day.