“R” is a standardized unit for assessing the reward and risk of trading strategies and trades. It allows for strategy and trade comparison regardless of risk tolerance, account size, or time frame.
Understanding R-related Terms for Trading
Here are some terms for understanding R values.
- 1R: is our ideal amount of risk. This is put in our trading plan as our “standard position” size. To understand how to come up with a standard position size see the position sizing articles for stocks or forex for more details on this. 1R is how much we want to risk on a trade; put another way, how much we are willing to lose on trade. For me, 1R is 1% of my trading account balance, for example.
That said, we don’t need to use this position size on all trades. We may end up with Fractional Rs (discussed below).
- R-Multiple: our profit or loss on a trade divided by the amount we intended to risk. If we risk $500 and make $2000 (2000/500), that is a 4R trade. If didn’t place a stop loss and lost $750 when we were only supposed to lose $500, that is a -1.5R trade (750/500).
If you are interested in really digging into your trading results, then you will also want to understand the following terms.
- Fractional R: when we choose to, or end up, risking more or less than our ideal amount.
- R-Theoretical: is what we plan to risk and make on a trade. For example, we may say this is a 3R or 3:1 reward:risk trade. We want to risk 1R to make 3r. This is relevant before the trade and while it is open.
- R-Actual: is what we actually end up making/losing on the trade in terms of R. We only know this once the trade closes/finishes.
I believe “R” was originally discussed by Van Tharp, whose work I appreciate. I have added in my own elements that I find beneficial.
Establishing What Your “R” or Risk Amount Is
If you hear me discuss trades or results, I will often speak in terms of R, such as being up 46R for the month day trading forex, or making 5R on a stock swing trade.
“R” is how much you are risking, and making, per trade. It is a standardized amount (dollars or percentage of account) for YOU.
R could be 1% of your account if you typically risk/want to risk 1% of the acount. Or it could be 2% or 0.5% of the account balance. Up to you. I typically risk 1% of my account per trade.
R could also be a dollar amount you are comfortable with, although I recommend this is also a percentage of your account, as over time dollar amounts tend to change as our account grows and shrinks. A percentage can remain stable over time.
If risking 1% of the account, that means on a $10,000 account you’re willing to lose $100 on a trade. The value of the position can be much more than $100 (for example, you could enter a trade for $5,000 or $10,000+ worth of stock), but if that position loses $100 you are getting out as that is 1R.
Many traders use a stop loss to define exactly when they will get out of a trade if it moves against them. Knowing the stop loss and entry point allows a trader to determine the exact position size they can take to risk 1% of their account on the trade.
The point is, YOU are choosing your R. It doesn’t matter if someone uses a different percentage or dollar amount.
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Trading Profits Expressed as R or R-Multiples
For every trade, you can now express your risk as R.
Your profit, expressed as R, is how many risk units you make on the trade.
If you set a 3:1 reward-to-risk for the trade and risk 1R, you will make 3R if the price hits your profit target.
If your 1R is 1% of the account, if you lose, you lose 1% of your account. If you win, your account increases by 3%.
Convert to dollars if it makes it easier. Divide what you expect to make by your risk amount.
If you typically risk 0.25% of a $475,000 account, your dollar risk is $1,187. If you stand to make (or actually make) $5,789 on the trade, that is 4.88R ($5789/$1187).
Another way to calculate your R profit is to look at the percentage difference between your entry price and stop loss price. Say there is a 5% difference. If you are going to take profit when the price rises 20%, that would be a 4R trade if the price hits your target. If you take profit at 50% above your entry price, that is a 10R trade.
Fractional R Trades
R is what you are comfortable risking per trade. But we may not risk that amount every time.
To find out what your factional R is, divide what you are actually risking by what you normally risk.
For example, we may usually risk 1% of our account per trade, but maybe market conditions are poor so we reduce our position size to half. If the price hits our stop loss, now we are only losing 0.5% of our account. I would record this as a -0.5R loss.
Or maybe we take a position size that is too large, or we don’t exit when we are supposed to, and we lose 2% of our account. I would record this as a -2R loss.
The same goes for a profit. If we only risk 0.5R, and win a 3:1 trade, we made 1.5R. We would have made 3R had we risked 1R.
Or maybe we end up with a position that is too big, so we are really risking 1.6R. If we are aiming for a 4:1 target, we will end up losing -1.6R or making 6.4R (because 1.6 x 4 = 6.4).
If it makes it easier, convert your R percentage into dollars. If your account is $123,690 and you typically risk 0.5% per trade, that means you can risk $618. If you notice you are risking a bit more or less, such as $675 or $580, this will change your R on this trade to 1.1R ($675/$618) or 0.94R ($580/$618) respectively.
This may vary slightly once the trade is complete. For example, you may have intended to risk 1R, but with slippage on the exit you end up losing 1.1R. Record the trade as a -1.1R loss.
Differences Between R-Theoretical and R-Actual
If we tell ourselves that we are going to hold for a 3R target on this trade (or a -1R loss), then that is what we should do unless our trading plan provides us with other options.
If the theoretical reward:risk on your trades is 3:1, then you should be making 3R on your winners. If your average actual winner is 1.5R, that tells you something is wrong. What you think should happen is not aligned with what you are actually doing.
- Maybe you are exiting your profitable trades too early.
- Maybe your profit targets are not reasonable (stop loss may be too big, making 3:1 very hard to reach), or the targets are not based on a sound method/strategy. Rather, they are based on whim or wishful thinking, not actual price chart data and statistics.
No matter the reason, it is good to know whether you are achieving what you set out to achieve. Many traders come to me saying they are winning a good amount of their trades and using a 3R or 4R target and yet they are just barely breaking even. The math doesn’t add up. They should be making a great profit.
The problem always lies in one of two things:
- They are making less R than they think. They set out to make 5R on a trade, but then close it early when they are onside 2R when the trade starts to turn a bit against them, for example. That is not a 5R trade, that is a 2R trade. You are your results, not your intentions.
- The R losses are bigger than they should be. Someone may be fairly disciplined, but occasionally there is a huge loss where they didn’t close their trade or didn’t use a stop loss and they lose -7R or -10R. Or maybe it’s less dramatic, but they’re constantly losing -1.2R, -1.5R, -2R, -1.3R, -1.6R. They are often losing slightly more than they planned.
This has a big effect on overall profit! If your actual average R loss is -1.3 (instead of -1R), you are not trading with the reward:risk that you think you are. For example, if you do average 3R on your winning trades. This should be a 3:1 reward to risk. But if you are losing -1.3 on your average losing trade, your actual reward:risk is:
- 3R / 1.3R = 2.3 Your reward:risk is quite a bit less than what you think it is!
Examples of R with Charts
The charts show how R and R multiples work, and how everything ties together.
The first chart uses an Earning Drift Trade Strategy with a trailing stop loss.
The following chart is based on the Contraction/Triangle PatternStrategy. This strategy uses profit targets based on how the stock moves.
We can see the reward:risk is 4:1, or we expect to make 4x the amount we risked, and in this case we did. You can also see what that equates to in terms of the percentage moves on the actual stock (6% stop loss, 24% target).
The following is a forex day trading chart. For most of these strategies I used a fixed 2.5:1 reward:risk, so I am risking 1% of my account and placing a target at 2.5x that. For example, if my stop loss is 2 pips, I place a target at 5 pips. My position size is what turns 2 pips into 1% of my account.
Notice that my actual R, what I actually made on the trade, is slightly different than what it should be. For example, making 2.52R or 2.48R instead of 2.5R. This is because the position size may be slightly off, or there’s a bit of slippage. Actual R often varies slightly from Theoretical R.
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Why Express Trades in Terms of R?
There are several reasons why expressing trading profits and losses in terms of R is useful.
R allows traders with different account sizes and risk tolerances to compare strategies and results.
If one person is risking $10 per trade, and another is risking $5,000, they can both express their results in R. If the $10 trader is averaging 3R per day, while the $5,000 trader is averaging 1R, the $10 trader is showing better skill even though the dollar amount he or she is making is way smaller than the dollar amount the $5,000 trader is making each day.
One person may only be risking 0.25% of their account per trade, and another may be risking 2%. Yet, if strategy results are expressed in terms of R, they can calculate their potential profit based on their own account size and risk tolerance.
For example, if a day trading strategy makes 30R a month, all the trader has to do is multiply 30 x the dollar amount of their R. If they risk 2% of a $6,000 account, their risk amount per trade is $120 x 30 = $3,600 profit. If someone else risks 0.25% of a $100,000 account their risk amount per trade is $250 x 30 = $7,500 profit.
R-Actual reveals mistakes in position sizing.
If you are constantly messing up your position size, R will show this because your losses will be a lot different than what they should be.
If you have a problem getting out of trades when you are supposed to, your average R loss will be bigger than expected, maybe -1.5R for example. You are losing 50% more on each trade than you should.
We don’t really need to worry about intentional fractional R trades, because our R-Multiple average tells us if we are doing well in terms of reward:risk. For example, maybe we are constantly risking 0.5R instead of 1R because trading conditions are poor. That is fine. If our average R-multiple is still 3R, we know we/the strategies are still doing well, even though we are trading smaller than we usually do.
R-Theoretical and R-Actual Show Us Reward:Risk Quickly
Reward:Risk, win rate, position size (which is already factored in if using R) and the number of trades we take determine our profit. That is it. By knowing your R values, you always know what your reward:risk is.
Take averages of your closed trades to see what your average R-multiple is. If it is low, and you aren’t doing well, you pretty much have your answer as to why. You need to hold for bigger gains.
Averages are very easy with R since our results are typically numbers like -1, +3, +2.6, -0.89, and so on.
Here’s how I calculate reward:risk:
- Add the profits divided by the number of profitable trades.
- Then add up the losses divided by the number of losing trades.
- Then divide average profit by average loss.
- Using the 4 trade above:
- Average profit = 5.6 / 2 = +2.8R
- Average loss = 1.89 / 2 = 0.945R
- Reward:risk = 2.8R / 0.945 = 2.96
- Our average profit is almost 3x our average loss.
If you add up all the profits and losses and then divide by the total number of trades, that gives your Expectancy. For example [ (-1 +3 +2.6 -0.89) / 4 ] gives us [ 3.71 / 4 ] or 0.93R. Assuming our results stay similar, we can expect to make 0.93R per trade, on average. That is expectancy expressed as R (and using R to calculate it).
To use R, you must define your risk before the trade.
Many people take trades without considering their risk. They don’t have an exit plan for a losing trade (and probably not for a winning trade either).
By defining R, we know exactly where to get in and out, because that is how our risk is determined.
Over many trades, we find out what our R-actual is, and we can work to reduce our losses to 1R or less, or increase our R-multiples.
R is about what happens at the account level.
R is based on the size of the account. If risking 1% of the account, and making 20R over 10 trades, you know your account is up 20%.
If you risk random amounts on each trade, who knows how much you made!? Yes, you can look, but the point is that the result is random because the position sizing and risk is random.
When we standardize our risk, it makes it much easier to track results and spot mistakes and areas of improvement.
Do I Need to Use R?
Of course not. Do what you want.
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By Cory Mitchell, CMT.
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.
Related
As someone deeply immersed in the world of trading, I can assert that understanding and effectively utilizing risk management tools is paramount for successful trading. The concept of "R" is one such tool that has gained prominence in trading circles, offering a standardized unit for assessing the reward and risk of trading strategies and trades.
Firstly, the term "R" itself represents the ideal amount of risk one is willing to take on a trade and is often put into a trading plan as the "standard position" size. For instance, if 1R is defined as 1% of the trading account balance, it establishes how much one is willing to risk or lose on a particular trade.
One crucial derivative of "R" is the concept of "R-Multiple," which is the profit or loss on a trade divided by the intended risk. A 4R trade, for example, signifies a profit four times the amount initially risked, while a -1.5R trade indicates a loss greater than the planned risk.
Fractional R comes into play when traders end up risking more or less than their ideal amount. This flexibility allows for adjustments based on market conditions or individual risk tolerance.
Two essential terms related to planning and assessing trades are "R-Theoretical" and "R-Actual." Theoretical R represents the planned risk and reward on a trade before execution, while Actual R reflects the realized outcome after the trade concludes.
The origin of the "R" concept is often credited to Van Tharp, with traders incorporating personal elements to tailor it to their strategies. Establishing one's risk amount, expressed in terms of "R," is a fundamental step in trading. This risk amount can be a percentage of the account balance, providing a standardized measure irrespective of account size fluctuations.
Expressing trading profits and losses in terms of "R" serves several practical purposes. It allows traders with different account sizes and risk tolerances to compare strategies objectively. Whether one is risking $10 or $5,000 per trade, expressing results in R facilitates fair comparisons.
Moreover, R-Actual serves as a crucial metric in revealing mistakes in position sizing. Deviations between planned and actual outcomes highlight areas of improvement, ensuring traders adhere to their predefined risk parameters.
The article emphasizes the significance of aligning R-Theoretical with R-Actual, as discrepancies may indicate issues with exit strategies, profit targets, or overall trade management. This alignment ensures that the trader's intentions align with actual results.
In conclusion, adopting the concept of "R" in trading provides a standardized and objective framework for risk management. By expressing trading results in R, traders can compare strategies, identify mistakes, and maintain consistency in risk across different trades and market conditions.
