# Why Defining Risk as "R" is Critical to Successful Investing

For this week's education article I want to focus on Van Tharp's "R" from his investment book, Trade Your Way to Financial Freedom.

So far this year I have 436 trades logged, and thanks to understanding "R", I can honestly say I've been more profitable and am on the path to becoming a far more consistent investor.

09/24 UPDATE: We've created a free basic "R" stock risk calculator to use on the site.

## What is "R" and How is it Used?

R is simply the dollar \$ risk per trade. It is another way of looking at a profit vs loss ratio.

Example 1

Let's say for example you buy 100 shares of stock at \$100 per share, so total investment \$10,000. If you define your cut off point at \$97 and set a stop loss order accordingly, your risk ("R") is then \$300 (100 shares x \$3 per share).

If the stock trades down to \$97 and you are subsequently stopped out of the position, your net loss is -1R (-\$300). Alternatively, let's say the stock moves up to \$106 and then you sell for a +\$600 profit, that would be a +2R winner.

Example 2

Now, let's say you bought 10,000 shares of the same stocks at \$100 per share. Using the same \$97 Stop, your risk is \$30,000 instead of \$300, however it is still 1R.

By translating each trade into R terms, you open yourself to a new state of mind and your ability to manage positions becomes far more effective.

## Position Sizing Magic Using R

By thinking in terms of R and calculating it with each trade, you can quickly and easily define risk for each trade. Furthermore, you will realize that despite investing roughly the same amount each time, your trades have been terribly inconsistent.

Let me explain.

Let's assume you put roughly the same amount of money in each trade. For these examples, we will use \$10,000 to keep things simple.

As I write this, Apple (AAPL) is currently trading at \$467.68, which would buy us a nice even 20 shares with our \$10k. If we determine our stop to be \$460, which is slightly below the 200 day moving average, our total risk would be \$153.60 (20 shares x \$7.68). \$153.60 is our initial R.

At the same time, we also determine Netflix (NFLX) to be a strong buy candidate, which conveniently right now is trading at \$302 even. Investing the same \$10,000, we can buy an even 30 shares (avoid odd sizes, ie 43 or 67, whenever possible). Let's say we feel \$300 is key support, so we set our stop at \$299, thus our total risk is \$90 (30 shares x \$3). \$90 is our initial R.

This is where it gets interesting.

Let's say both stocks run 5% higher and we sell to lock in a profit. Our Apple trade would yield us \$467.68 in profit (20 x \$23.38), and our Netflix trade would return us \$453 (30 * \$15.1) in profit.

\$467.68 (AAPL) and \$453 (NFLX), both roughly 5% profits off each initial \$10,000 investment. Great right? No problems here.

Wrong.

The difference is that with Apple we risked \$153.60 to make \$467.68, so using R our return is +3R, whereas with Netflix, since we took less risk (\$90), our return is actually +5R. A huge difference of 60%+!

Now imagine making 100s of trades over xx years without using R vs using R. You can quickly figure out that your returns would differ dramatically.

By defining risk using R, a completely different story is told under the surface. Not only can you manage positions equally (risking the same amount \$ on each trade), but you can tweak your strategies to focus on higher Risk / Reward trades moving forward.

## R is a Tool to Limit Risk

Many, many, many successful investors over the years talk about limiting risk as one of the critical keys to long term success with investing:

"At the end of the day, the most important thing is how good you are at risk control. Ninety-percent of any great trader is going to be the risk control.” - Paul Tudor Jones

"The elements of good trading are: 1. Cutting losses, 2. Cutting losses, and 3. Cutting losses. If you can follow these three rules, you may have a chance." - Ed Seykota

"The golden rule of trading is to keep losses at a level of 1 R as often as possible and to make profits that are high-R multiples." Van Tharp

By defining R with each trade you have the power to quickly determine not only what your R value is for winners, but also losers.

Look at your losers and see if you have ever lost more than -1R (your original risk). More than likely you have. The question is how much more and why.

It is common to experience slippage and have orders executed lower than the preset stop. This is especially true for those trading larger position sizes. So, a -1.1R might be common. But, if you are seeing -2R, -3R, or heaven forbid -4R losses or more, you have identified a serious flaw in your trading. You can't cut your losses!

Create a new column in your excel sheet trade journal right next to your % return column so you can see the R result to quickly analyze past R values. Then, average them together to determine your average R.

It is inevitable that you will have losses over -1R or less than -1R. But, they should never average out to anything below -1R. If they do, you have one big hole in your trading, which is a good thing, because it means you have room for improvement.

Just like the most successful investors of our time, you too can cut your losses short, and by using R, you can quickly determine how well your efforts have panned out. Do it.

## Determining Strategy Success Using R

The last piece of calculating R is determining the overall success or failure of any given investment strategy.

With all your trades logged away and organized by strategy, you can quickly determine the real results. Take all your R returns, sum them up, and you will have your net R return for that given strategy or group of trades.

If it is positive, congratulations. If it is negative, congratulations as well, you have an opportunity to make a change right now today and improve as a trader.

Whether you are a day trader or a long term investor, the end goal is always the same: return maximum R in the shortest amount of time.

You might think that your long term strategy that yields a 100% return, a +10R winner, is your best. However, if each +10R winner takes you on average 3 three years to achieve, you may find that your shorter term trading strategy which yields one +30%, +3R winner every 6 months is more successful and a better place to focus your energy.

Remember, the R \$ dollar value is ultimately irrelevant once it is equalized for each and every trade. If your R is \$100 for every trade you make, then you can use R to quickly calculate success. +30R over 20 trades means a +\$3,000 return, and so on.

Investing is about long term sustainability. Learning to always calculate and think in terms of R is a great step towards getting there.

## Real Life Examples

To illustrate how R is used in live trading, I have included four trades (2 winners, 2 losers) from one of my personal portfolios (I use the TD Ameritrade thinkorswim platform for day trading) below for you to observe.

Every trade I make is recorded in my excel sheet, and afterwards I take a screenshot then add my buy (purple), stop (blue), and sell (orange) points alongside notes and end results. This allows me to learn from every trade, winner or loser, and improve over time.

(PS - Post trade analysis is another critical piece to successful long term trading.)

## Key Summary

In summary, "R" can be broken down as follows:

• R is total \$ risk. if you buy 100 shares of a \$100 stock and your stop is \$99, then your initial risk (R) is \$100 (100 shares x \$1)
• By calculating R for each trade, you will learn that the total \$ amount invested in each trade does not matter, it is total amount \$ risked (initial R) that matters.
• No two trades are equal unless they have the same initial R value. A +\$500, +5% profit as a +5R return is far better than a +\$500, +5% profit as a +1R return simply because there was far less risk required to achieve the result.
• To determine success of a strategy or group of trades, determine the net R for each trade then sum them together. Average your losers together to ensure you are always cutting losses short.
• Using R is one big key towards long term sustainable, successful investing.

Do you calculate R and use it in your trading? What has your experience been with it? Has it made you a better investor? Shares your thoughts via comment below or chat with us on Facebook.

1. Posted by on September 15, 2013 at 4:43 am

By far the best summary explanation of this concept I have ever read. Well done.

2. Posted by on September 15, 2013 at 8:32 am

Thank you AT, appreciate the support. Took quite a while to put together but very pleased with the final product.

3. Posted by on September 15, 2013 at 10:33 am