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Trading the R's
Learn how to mitigate risk.
Thanks so much for reading this particular article! How valuable and relevant the following information is, especially as it relates to trading.
Every website, stock column, company or 'trading guru' will tell you how important risk mitigation is. Consider me to be neither of these four. I am just a guy who loves education and one day decided to combine that love with my zeal for finances, investing and of course the stock market.
First, to define 'R trading' - This is a concept that has been around for a few years. It is an incredibly simple formula [that almost NO other company will teach you] and I'm going to do my best to break it down very quickly. The reason I'm creating such a succinct article about R trading is because you will hear me use this term ALL the time in videos, emails and in our day trading and swing trading rooms.
If you do not like reading but prefer watching or listening, here is this article in webinar form.
An 'R' simply stands for Risk Unit.
Many people have an intense and visceral connection to money. It's very hard to break this relationship because money can buy us things. That's about all it can do. Money is just a tool. Are you in love with the hammer in your garage? Do you treasure it, think about it and constantly try to get more hammers? Money is simply a tool, which can be used to literally build and grow more wealth and security. Therefore, you can either use your hammer or stand in awe of its illusiveness.
In trading there are two facts:
#1 You will lose money on trades
#2 You will be wrong on trades
If you've been battling with this issue for years and constantly find yourself trading out of deficits, blowing out your accounts, and you're always 'broke', hop over to this article at some point. It is much longer and goes more in-depth into this psychology. For now, I'm just going to explain R trading and I'm going to do it for free.
R = Risk Unit.
Instead of risking money, or trading money, you are breaking that emotional barrier by giving it a less cool name. It's no longer money that you are trading, just risk units. Boring, plain old risk units.
Your goal? Risk small, win big. Lose small, win big. Cut your losers and let your winners run. Risk less than your potential reward. You know, all of those nomenclatures. Here's how to calculate it.
The R you trade should be approximately 2% of your entire account. It can certainly be less. It can be 1% or .5% or .25. You get to determine and pick the risk percentage. Usually (especially for newer traders) the smaller the better when starting.
If you have a $5,000 account your R = $100.00 100 = 2% of 5,000.
If you have a $9,504 account your R = $190.08 (You could round up to $200 or round down to $190 if you wanted to).
If you have a $103,716 account your R = $2,074.32. (Again, you could round to $2,075, $2,100, $2,050, but somewhere in that general range).
Your first question is, 'Jerremy, if I have a $5,000 account, you are saying I can only spend $100.00 per trade?
Nope. That is not what I am saying.
I am simply stating that $100.00 is the amount you should be willing to lose on the trade. That's your Risk Unit, or your R. The amount of investment, or your 'position size', is not as important as most people make it out to be. In my opinion, the more important factor is the potential risk on each trade (i.e. how much you lose if you are wrong). Warren Buffett's famous quote, "The #1 rule in trading, don't lose money".
Your goal is obviously to lose as little as possible. Risk mitigation and defense is your concern and focus. If you prevent yourself from totally destroying your account, you can trade longer. After all, if does require money to trade! (I know. I've been called Captain Obvious before.)
How to calculate with shares
R / stop value = amount of shares to trade
A trader wants to enter AAPL and they plan to buy shares as it bounces off of $120 as a support price. They look at the chart and determine $118 to be a good price for a stop. The stop value in this scenario is $2.00, which is the difference between the entry price and the stop location.
Let's say the above trader has an R of $100.00
R = $100 / $2.00 stop value = 50 shares to trade. The investment would be $120 x 50 shares, or $6,000.00. The risk, however, if that trader is wrong, is only a $100.00 loss.
Same trader. Different stock.
A trader wants to enter FB and they plan to buy shares as it bounces off of $81 as a support price. They look at the chart and determine $80 to be a good price for a stop. The stop value in this scenario is $1.00.
R = $100 / $1.00 stop value = 100 shares to trade. The investment would be $81 x 100 shares, or $8,100.00. The risk, however, if that trader is wrong, is only a $100.00 loss.
Two different stocks, same loss potential. Therefore, if FB goes up and AAPL stops the trader out for a loss, the trader can be right only 50% of the time and still make a profit. If FB bounces from $81 and goes up to $90 and makes 9R on this trade, while only 1R is lost on the AAPL trade, that's a total of 8R gained. This trader created a plan, followed it, mitigated losses, and made a profit. Boom. That's smart!
How to calculate when buying call or put options
R / stop value = amount of shares to trade. Then convert that into option contracts.
Many analysts and companies make this more complicated than it needs to be. I will say simply, if you need a rough, quick, down and dirty way to calculate risk on an option trade, this formula works. It's at least close enough. The reason I say that is because options can change and fluctuate in price regardless of what the stock does. Therefore, it's nearly impossible to get this formula exact unless you use purely the option price (which you don't really want to do either), but I'll show you how.
A trader wants to enter AAPL and they plan to buy shares as it bounces off of $120 as a support price. They look at the chart and determine $118 to be a good price for a stop. The stop value in this scenario is $2.00, which is the difference between the entry price and the stop location.
Let's say the above trader has an R of $1000.00
R = $1000 / $2.00 stop value = 500 shares to trade. How many contracts control 500 shares? Answer = 5 contracts. Each contract controls 100 shares. Therefore, if a trader bought 5 contracts and had an R of $1,000, this math would give a pretty close approximation of future loss.
Same trader. Different stock.
A trader wants to enter FB and they plan to buy shares as it bounces off of $81.58 as a support price. They look at the chart and determine $79.54 to be a good price for a stop. The stop value in this scenario is $2.04.
R = $1000 / $2.04 stop value = 490 shares to trade. How many contracts control 490 shares? Answer = 4 contracts. Each contract controls 100 shares. What about the other 90? This is where discretion comes in. A trader could easily understand if four contracts were bought, the loss would likely be less than $1,000. If five contracts were bought, the loss could still be slightly less than $1,000, at $1,000 but likely a tad more than $1,000.
Two different stocks, same loss potential. Therefore, if FB goes up and AAPL stops the trader out for a loss, the trader can be right only 50% of the time and still make a profit. If FB bounces from $81.58 and goes up to $90, the trader gains some R's and loses only 1R on AAPL. Great risk mitigation!
Again, really simplistically, a trader could buy 10 option contracts, which cost $2.40 each. An investment of $2,400.00. If the trader has a $50 R, the stop on the actual option price itself could be $2.35. However, that could easily be the bid / ask spread on the option. Option trading is a tad more advanced and I'm happy to teach you (for free). Click here for that class.
Thank you so much for reading this information! Understanding risk mitigation is always the key in trading. The longer you protect your money, the longer you will have money to trade. Create a trading plan, follow it, mitigate risk and of course, Love life, Live life and Trade it!