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Why R is the Most Important Letter in Trading
R in trading parlance is simply a uniform unit of risk with all your rewards are expressed as multiples of R. So a simple 10 pip stop and 20 pip target is a 2R trade. R can be expressed as pips, points, or dollars -- whatever suits you. The primary value of R is that it normalizes risk across all your trades, or bets as I like to call them.
Now the internet is full of “R Billionaires” -- traders who claim in podcast after podcast that they have a 70% win rate and 2.45R average. (Just to show you how ridiculous that is -- it’s a 145% return without any leverage or taking $10000 to $77 Million in 10 years). But trader bulls-t aside, R is a very useful tool that should be part of our trading process regardless of what strategy we use.
It’s essentially a risk framework, that can quickly tell you how and why you make or lose money in the market. But before we delve in further -- allow me to digress. I stated above that we should stop calling trades -- “trades” and start thinking of them as bets.
Because the word “trades” has a false connotation to it. Trades imply open-ended narrative structures that can turn into psychological crutches as we hang on to the story arc long past its ending because we are convinced that we are “right”. Bets, on the other hand, are binary and final events- which is exactly how we should approach what we do. As traders, we don’t “invest” in stories, we make market bets and play the odds via R. (Yes, I have been reading a lot of Ray Dalio lately and regardless of whether you think Bridgewater is a cult or not, his philosophy of radical transparency is the perfect way to view our role in the market)
Lastly, stop thinking about daily, weekly, monthly, annual returns. The question -- how much can I make this year should never enter your mind again. Time is a completely artificial construct. Annual returns are simply marketing bulls-t pumped out by Wall Street for civilians who have no clue how markets work. The only way to honestly evaluate your performance is over a number of bets and 100 is as good a round number as any. So, if you can achieve some positive multiple of R over 100 bets. You. Are. Winning. At. Trading. Everything else is just noise.
Now, in reality, 2R trades happen 25% of the time (did you really think the markets would give you any more than that?) Occasionally, certain strategies and certain pairs can give you 30%-32% win rates on 2R trades and that is as good as it can get, because just like a casino with 51%-49% advantage in roulette, you can make a lot of money out of a
The key, of course, is to mitigate risk as soon as possible. There are two ways to do it. You can move the stop to breakeven as soon as trade goes 1R in the money and then wait for 2R to hit 31% of the time. If the b/e stop happens 50% of the time you are well ahead on this strategy. (Simple math -- 50 bets you lose 1R, 31 bets you make 2R, net result +12R). But that’s tough to do psychologically. We like to get paid more than 31% of the time. So most traders use a T1/T2 approach that I’ve talked about before. In that scenario, you start with 2R risk, exit half the trade at 1R move stop to breakeven and exit 2nd half at 2R. In fact, the nirvana formula for such an approach is 45-55-30 split where you lose 45 trades make 1R on 55 trades and make 2R on 30 trades. If you can do that consistently you actually will be an “R Billionaire” one day.
Looking at markets through the prism of bets and R has really helped me spot my own weaknesses much quicker. About 4 weeks ago after a very long period of focusing only on systems, I started doing weekly prop trades for BK (basically K beat me into submission into doing it). The results are seemingly exemplary. I am up more than +500 pips on the recs despite Trump’s best efforts to disrupt the FX markets on a daily basis. But taking a look closer at what I was doing I realized that I had a glaring flaw in my approach. I’ve been using 100 pip stops 40 pip T1 targets and 100 pip T2 targets for essentially a maximum .7R. Generally, you want to keep your maximum R at 1 to 1.5 so that you can be positive on anything better than 50%. Not only was I making inferior trades but I was taking on risk that was utterly unnecessary. None of the winners ever went 50 pips against me. So going forward I am cutting stops to 70 pips -- that’s still not perfect -- but it does put me at 1R maximum bet which should be a much more resilient structure if I can stay above 50% win rate.
Up to now, I’ve been lucky. Going forward with better R, I hope to be good. Be sure to start using it in your own trading.