## Wednesday, August 15, 2012

### The concept of R

R is an important letter in my trading world. It quantifies both the risk I place on each trade, as well as giving the reward achieved in relation to the equity risked when opening a position.

As everyone has their own ideas on risk management parameters, it can be argued that the overall R achieved can be calculated by all traders in a uniform manner.

All things being equal, the reward to risk ratio should be as high as possible - this, combined with the win percentage, determines the overall expectancy of your system.

As trend followers, we are used to having a historical win percentage below 50%. However, as we strictly control our losses, and let our profits run, we end up with an overall positive expectancy.

Take an example whereby the win rate is only 40%, yet when averaged out our wins are three times bigger than the size of our losses. This creates an overall expectancy as follows:

(40% x 3) - (60% x 1) = 1.2 - .6 = +0.6R

In this example, we achieve an overall expectancy of +0.6R, which means we gain an average of 0.6 times what we risk across the total population of all trades (winners and losers).

So, if you were risking say £100 per trade, in theory you earn an average of £60 for each trade taken, regardless of whether its a winner or not. Two things to bear in mind here:
• The above example does not account for slippage, execution errors, etc.;
• This assumes you risk the same monetary amount on each trade ad infinitum
When calculating your overall expectancy and your average R per trade, you also need to ensure that this is calculated over a meaningful sample of trades, as well as taking into account both favourable and non-favourable market conditions.

The average R will remain the same whether you trading a £10,000 account or a £1million account. If, however, you use fixed fractional money management, and increase or decrease your position size (in monetary terms) based on your actual performance, then the beauty of compounding your equity will mean that, providing you are using a system with an edge, your position size will increase over time. If you are able to maintain your average R going forward, then your account balance will start to increase sharply.