Do You Understand Your "R"?

"R"isk is the single most important factor YOU CAN CONTROL in the marketplace. Once you enter a position, you are at the mercy of the market to prove that idea right or wrong. We simply have no control over what the market does with our money once we put it on the line, but what we do have control of is (roughly) how much we are willing to lose if this idea happens to be wrong.

In investment lingo we call this notion "R". R is risk, R determines how much of a asset you can own and it determines when that situation is moving outside of your comfort zone. Knowing what R means is one thing, putting it into practice is another.

Quite simply R is the amount of money (in dollars) you are willing to risk on a bet. The way we derive this number depends entirely on you and your individual risk tolerance. For the sake of discussion we will use the risk parameters I set for my own trading systems, which is 1R or 1% of my total portfolio value. I am willing to risk 1% of my trading capital on any one position. That ensures that even if I suffer a string of losing trades, I will still have substantial equity to continue my positive expectancy trade plan. Lets assume your investing account is worth $10,000. 1% of 10,000 is 100. So if you put into practice a 1R risk level, you are willing to risk $100 on any one trade.

Next lets use this risk amount to determine how much of a stock we can buy in one sitting. If we can lose $100 on the trade and be within our predetermined risk tolerance, you need to figure out how many shares of the stock you can own while only risking $100. Lets say you want to buy Verizon (VZ), VZ currently trades near $50.

The first thing we want to do is look on the chart where the major support is and where your trade will be proven too high risk. At a glance, the $46 level looks like the major support. So we have our entry price $50 and we have our key support (stop) at $46. The way we calculate risk is to take the difference of our entry price 50 and the stop level 46, that equals 4. We risk $4 per share if we buy VZ with this method.

Now we know that we can stand to lose $100 per trade and with our entry here we can lose $4 per share. So we divide 100/4 and get 25. We can buy 25 shares @ $50 per share with a stop at $46 and be within our 1R risk preference.

Trade Re-balance
Once we know how to determine our R, we can assess risk at any point during our trade. An idea that was presented to me some time ago was the idea of maintaining proper balance of your portfolio using your R amount. This is called Open Equity Risk. Lets say for the sake of argument that after our VZ entry that the stock surprisingly jumps to $55 very quickly. Trailing stops and moving averages tend to lag the current price action and have a hard time adjusting to such a quick, violent move. That leaves us in a slightly uncomfortable position in that you have a trade with a dramatically higher price and your stop is still in its initial place. What was once a 1R risk from 50 to 46 is now stretched over 2R from 55 to 46.

We can determine if we want to continue the trade untouched and let it just ride, or we can see how our risk has changed with this recently changed environment. We are going to figure our risk exactly like we did originally but with the new range of price. The difference of 55 (current price) and 46 (stop) is 9. If we have 25 shares with $9 per share risk we now have a total open risk of 9x25= $225. We had previously determined that we could risk $100 as our 1R figure on any trade, and while technically we still risk that original $100 amount, we now have a new situation to deal with. If the market where to move against us from here and stop our trade out, we would have lost $225.

This idea is what is known as Open Market Risk and is a topic of some debate. Whether you choose to continue to hold the position as is or you reduce your holding size to account for the risk is a personal preference. The way you would bring your portfolio back into balance of 1R would be to simply determine how many shares you could own at $55 with a stop at $46 where you are only risking $100. $9 is our difference between current prices and the stop and 100/9 is 11. Therefore you could own 11 shares to be within your 1R, so you would sell 14 shares at the current price. This way, you can book the gain, maintain a position in the uptrend and keep your portfolio and trade within your risk tolerance.

Adding to Positions
I use R all the time in my trading, one place in particular is when I have a new Add signal for a current holding. Once a stock triggers a new Buy signal based on my system, I determine the stop placement after the breakout and figure my R based on the breakout price and the new stop price.

Lets look at a trade in motion currently: I have eyes to add to ECL if the breakout early this week can carry into the weekly close Thursday (Friday is the 4th of July).

 With this potential breakout this week, it looks like I will be able to trail my stops up to the swing low just above $106. We will assume for this example that price closes around this $111.60 area and we will use that as an initial level to determine the current open risk we would have in the position.

With current prices at 111.60 and the expected stop to be about 106 that leaves us with 5.60 as the amount per share that is currently at risk; I currently hold 37 shares of ECL.

5.60 risk per share multiplied by 37 shares equals $207 of total open risk. Now the 1R on this particular account is $400 so it would appear that I am under-invested based on a 1R risk guideline. Therefore I can add to the position on a confirmed signal, up to a $400 total risk or roughly double my current holding size.

As a side note: I rarely would double the size of a current holding for a continuation signal. Most likely I would add half again as much and just be content to have a slightly less risky position. Just because you set a 1R limit on your risk doesn't mean you have to push that limit on every position. Sometimes it is best to simply hold a .5R, but in a situation where the stock is acting right and generating a new signal, that is where I look to take advantage of a lower risk situation and increase my exposure.


--With that little lesson, you should have a good feel for how to keep your risk in some way organized. That is THE key to this whole game. If you can keep your risk in control, your profits will take care of themselves (provided you don't attempt to sabotage yourself by taking premature gains too soon). Understanding how much you can risk will keep you playing and learning without seriously jeopardizing your long-term plans. Always know your stops, keep a balanced portfolio where excess risk isn't lopsided, and continue to calculate your R and you will be on your way to success.