In this article, we will expand the notions presented in the first part of the series. If you haven’t read the first part, you can check it out below in our related ideas section.
We define risk as to how much you’ll lose per unit of your investment if you are wrong about the position. We called this in the first part initial risk (1R). All your profits and losses should be related to your initial risk.
Example 1: You buy a stock at $100 and decide to sell it if it drops to $80. What’s your initial risk? The initial risk is $20 per share. So, in this case, 1R is equal to $20. If you buy 10 shares then your total risk is $200. R represents your initial risk per unit.
Example 2: You want to do a foreign exchange trade with a 10k account, selling the EURUSD. Let’s say that $100 USD is equal to 77 Euros. The minimum unit you must invest is $10,000. You are going to sell if your investment drops by 1k. What is your risk? What’s 1R for you?
It may sound complex, but it is very simple. If you’d close your position if it drops 1K from 10k to 9k, then your initial risk is $1000 and that is equal to 1R.
R represents your initial risk per unit.
Let’s say that you have noted on your trading journal the following trades:
1. 400 CSCO at $23 - R $1000 - P&L $2,317 2. 80 IBM at $80 - R $1000 - P&L ($813) 3. 300 VLO at $50 - R $1000 - P&L $3,413 4. 400 HRB at $51 - R $1000 - P&L ($1,531)
The R multiples for these trades are: 1. 2.32 R 2. -0.81R 3. 3.41R 4. -1.53R
The average R for your system is: 0.84R
Expectancy really refers to the mean (average) R-multiple of your system. As a trader, if you want to be successful you need to start quantifying your trading performance. You should always calculate your R-multiple and it’s average (expectancy).
The expectancy of your system is the average of the R-multiples (both positive and negative) of your system. It tells you what you can expect in terms of R, on average over many trades.
This information is pretty straightforward and easy to grasp. In our example above if we have a system with an expectancy of 0.84R and we risk 1% per trade we should expect a profit of 0,84% per trade. After 100 trades you should be up 84%! The average however is not the total picture!
To understand how much your system can deviate from the expectancy, you must not only know the average R-value, you must also know the variability of R or standard deviation. The variability will tell us how far away from the mean most samples are likely to be. It would be great if all samples were at mean, but this is never the case because it would mean that there is no variability to the sample.
Now you truly understand why the 3rd and 4th golden rules that we mentioned in the first article are very important!
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