Tuesday, May 27, 2014

Learn to evaluate your trades in terms of R

Occasionally you will come across people who record their gains (and losses) expressed as a percentage movement in the share price. While this is great to know, does it add any value in terms of quantifying your method or profitability?

In my opinion, whether a stock moves 10% or 100% after you have opened a position is irrelevant. What IS of far more interest is your profit or loss expressed in terms of R.

Remember that R is the figure calculated when you divide the profit or loss generated by the initial amount risked. So, for example, a £2,000 profit on a trade where you originally risked £500 equals a 4R profit. A £250 loss while risking £500 equates to a -0.5R loss.

A stock can increase by say 50% on its share price after you have entered, but if you used a very wide stop this may only equate to a small profit in terms of R.

A lot of successful traders use some form of volatility measurement to calculate where there initial stop should be placed (e.g. The Turtles). Others use some price level which may have acted as a prior support or resistance level (such as Nicolas Darvas and his box theory). Once this level is known, along with your entry price, then you can calculate your position size based on a) the amount of equity you are prepared to risk on the trade, and b) the distance between your entry level and your intended stop level.

Suppose you had two potential stocks priced around the same level of say $10. Based on your calculations, stock A would have its initial stop placed at $9.50. For stock B, this level is calculated at $9. Therefore, all other things being equal, your position size on stock A would be twice as large as that for stock B, but the overall monetary risk would be equal. Furthermore, with stock A price has to move a shorter distance than stock B to make a similar level of profit.

Now suppose that you entered both positions, and that the subsequent exit was triggered at $15. With stock A, you will have made a 10R profit (being the $5 movement in price divided by the initial risk of 50c). With stock B, you would only have made a 5R profit.

"Frankly I don't see markets; I see risks, rewards and money." - Larry Hite

It therefore goes without saying that, if you have the choice between those two stocks, then stock A would be the one to go for, as the potential reward:risk ratio is better.

How do you look for such opportunities? One thing I do is look for stocks that have shown a contraction in volatility. Generally this will mean that the initial stop could be placed closer than a stock which has been more volatile.  When the entry is triggered, then you would look for an expansion in that volatility in the direction of your trade. Read more about this here.

"When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion." - Paul Tudor Jones

This approach works regardless of whether you are a day trader or a trend follower, or whether the stock is seen to be a low value stock (some traders tend to shy away from such stocks) or the higher valued ones.  Whether it is a $5 stock or a $50 stock, or whether price moves 1% up from your entry point, 10% or 100%, learn to evaluate your trades and overall performance in terms of R.

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