Systemizing Risk Management Through R-Multiples

Key Takeaways
Through the previous sessions weve learned that good risk management is a combination of
correct position sizing and correct trade management. The former is all about taking small
percentage risk per trade, and the latter is all about consistently ensuring that you dont take
losses that are larger than your small predetermined risk by always being disciplined with stop
losses.

To systemize and simplify the whole process of risk management so its easy to understand,
implement and track, you can use the concept of R-multiples. This concept has been used for
decades by professional traders and money managers. It was introduced and popularized to
the public by prominent trading coach and psychologist Van Tharp, who we all owe a big debt
of gratitude.

In any trade you take, you have an Initial Risk = R. If youre using the % risk model, this R will
always be equal on any trade you take in terms of percentage of your account balance. In this
way, different setups and different markets can have equalized risk always represented by R,
no matter how large or small the stop-loss is (because the position size will adjust for the stop
size to keep % risk constant). So you represent each initial risk with R, no matter the size of the
stop-loss.

The R-multiple is simply a positive or negative multiple of R. If you have a profit on the trade,
you will have a positive R-multiple. If you have a loss, you will have a negative R-multiple. For
example, if youre using a 2 point stop-loss and you have 4 point winner, your R-multiple is 2.
That is, youve just made 2 R (or twice as much as you risked). If using a 4 point stop, you have
an 8 point winner, your R-multiple is also 2. If using a 3 point stop, you have a 3 point loser,
your R-multiple is -1, and youve lost 1 R.

Using R makes expectancy very easy to calculate. Simply add up the total R of all the trades
youve made and divide by the number of trades. You can do this because expectancy is
nothing more than the average profit (or loss) per trade. i.e. How much can you expect to
make (or lose in the case of a negative expectancy) per trade.

To calculate expectancy and R-multiples correctly, you have to include the commissions you
pay. To do that, you simply equate the commission to the point value of the instrument you
trade. For instance, if you trade the ES (S&P 500 Futures) and you pay $5 commissions per
round turn (i.e. as a total commission based on entry and exit), then this commission equals 0.1
ES points (since each ES point equals $50). So if you have a 2 point stop, your R is actually 2.1
points because thats how much youll lose on the trade when commissions are added in (i.e.
thats your true risk). If now you make 4 points in profits, your actual net profits are 3.9 points

Copyright 2012 OpenTrader Training, LLC. All rights reserved.

 (4 - 0.1). So your R-multiple would be 3.9 / 2.1 = 1.86 R. If you lose 2 points, your real loss
would be 2.1 points, so it would be a -1 R trade. If you trade the NQ (NASDAQ 100 Futures)
with $5 round-turn commissions, it would be equal to 0.25 NQ points, because the NQ trades
at $20 a point. If you trade stocks there would be no need to convert anything because stocks
dont have a point value. You would just add in the $ commissions.

To compare different trades and see which one was truly better, you simply look at the R-
multiple. The one with the higher R-multiple was the more profitable trade, regardless of the
number of points the trade earned. For example, lets say you have a $20,000 account and risk
2% per trade. Your risk is currently $400 a trade. On trade 1, you have a 2 point stop and get a
5 point winner. Forgetting about commissions for simplicitys sake, this would have been a 2.5
R trade, which means you made $1000 (you know its $1000 because 2.5 x your R of $400 is
$1000, and also because your position size must have been 4 contracts to give you $400 risk on
a 2 point stop, and 4 contracts x 5 points x $50 a point = $1000). On trade 2, you have a 1 point
stop and you get a 4 point winner. Now even though this winner is a 1 point less than the
previous one, its actually the more profitable trade and you can easily see this when looking at
R-multiples. This is a $1600 winner, because its a 4 R trade (4 x $400, or 8 contracts x 4 points
x $50 a point).

So tracking R-multiples automatically forces you to think in terms of Reward-to-Risk. Youre no

longer looking at how many points you made on a trade, but rather at how many points you
made in comparison with how many points you risked. The multiple is what matters.

Using R-multiples also simplifies everything because now can now compare different setups,
trades, timeframes, or markets, all on an equal risk basis. Even if you use different % risk for
different setups or markets, you can still compare the pure edge of the trades through R-
multiples. The different % risk will just be a matter of higher or lower position sizing, but the
edge will be determined through expectancy which can be calculated simply by adding up the
R-multiples and dividing by the # of trades even without knowing what % risk is used on any
given trade.

Most importantly, using R-multiples brings together all aspects of risk management and forces
you to use them. To even use the concept of R, you have to have a stop-loss, and you have to
be using a consistent position sizing model to size each R appropriately, and you have to stick
to your stop-loss because your goal will be to never have a loss thats great than -1 R. Those
losses will quickly damage your expectancy, and youll always be on alert to not let them
happen because your focus is on R and expectancy instead of on trying to avoid taking losses.

The side benefit is that it also switches your focus from accuracy to large Reward-to-Risk
trades, as you start trying to get the large R-multiples that can really improve your expectancy.

Using this system and recording your trades in an Excel file or journal in this way will give you a
complete risk management system that will allow you to survive for the long-run and become a

Copyright 2012 OpenTrader Training, LLC. All rights reserved.

consistently profitable trader. Its the simplest and easiest way ever devised to help you
achieve this goal, so be sure to use it, because your competition is.

Copyright 2012 OpenTrader Training, LLC. All rights reserved.