Start Thinking In Terms of Risk-Reward

One of the cardinal rules of good trading is to always have an exit point before you ever enter into a trade. This is your worse case risk for the trade. It's the point at which you would say, "something's wrong with this trade and I need to get out to preserve my capital."

Most sophisticated traders will have some sort of exit criteria that they like. However, if you are a novice and you just don't know, then I'd recommend 75% of your entry price if you are an equity trader. That is, if you buy a stock a $40, then get out if the stock drops to $30 or below. If you are a futures trader, then calculate the average true range over the last ten days and multiple that result by three. If the contract drops to that level, then you must get out of the position.

Your initial stop defines your initial risk. In the example of our $40 stock, your initial risk is $10 per share and I call this risk 1R (where R stands for risk). And if you know your initial risk, then you can express all of your results in terms of your initial risk.

So let's say that your initial risk is $10 per share. If you make a profit of $40 per share, then you have a gain of 4R. If you have a loss of $15 per share, then you have a 1.5R loss. And losses bigger than 1R will occur when you have a sudden big move against you.

Let's look at a few more. What if the stock goes up to $140, what's your profit in terms of R? Your profit is $100 and your initial risk is $10, so you've made a 10R profit.

It's quite interesting because portfolio managers like to talk about 10 baggers. By a 10-bagger, then mean a stock that they bought at $10 per share that goes up to $100 – in other words a stock that goes up in value 10 times. However, I think a 10R gain in much more useful to think about and much easier to attain.

When our 1R loss was $10 per share, then the stock had to go up by $100 to get a 10R gain. But to fit the portfolio manager's definition of a 10 bagger it would have had to go up 10 times the price you bought it for, going from $40 per share to $400. But what would that $460 gain be in terms of R-multiples when your initial risk was $10? That's right, it would be a 36R gain.

What I'd like you to do before next week is to look at all of your closed trades last year and express them as R-multiples. In other words, what was your initial risk? What was your total gain and loss? What's the ratio of each profit/loss to the initial risk? And if you didn't set your initial risk for your trades last year, then use your average loss as a rough estimate of your initial risk.

Let's look at how 10 trades might be expressed as ratios of the initial risk. Here we have three losses $567, $1333, and $454. The average loss is $785.67, so we'll assume that this was the initial risk. Hopefully, you'll know the initial risk, so you won't have to use the average loss. I call the ratios that we calculate, the R-multiples for the trading system. This information is shown in the table below. 

When you have a complete R-multiple distribution for your trading system, there are a lot of things you can do with it. But we'll save that for next week's topic.