By Dr. Van Tharp
Tell me more about Risk or (R)
Risk to most people seems to be an indefinable fear-based term. It is often equated with the probability of losing, or others might think being involved in futures or options is “risky.”
Van’s definition is quite different to what many people think. As far as Van is concerned, risk is definable. Many people in the investment world are overly optimistic about the trades that they make. They don’t understand their worst case risk or even think about such factors.
Instead, people are seduced by trading terms such as “options”, “arbitrage” and “naked puts,” or, they buy into the academic definitions of risk such as volatility, which make for good theoretical articles by academicians, but they totally ignore two of the most significant factors in success. The golden rules of trading:
- Never open a position in the market without knowing exactly where you will exit that position.
- And cut your losses short and let your profits run.
So let’s look at the first golden rule in much more detail to be sure that you understand it. That rule is to always have an exit point when you enter a position. The purpose of that exit point is to help you preserve your trading/investing capital. And that exit point defines your initial risk (1R) in a trade.
Let’s look at some examples.
You buy a stock at $50 and decide to sell it if it drops to $40. What’s your initial risk? The initial risk is $10 per share. So in this case, 1R is equal to $10.
You buy the same stock at $50, but decide that you are wrong about the trade if it drops to $48. At $48 you’ll get out. What’s your initial risk? In the second example, your initial risk is $2 per share, so 1R is equal to $2.
You want to do a foreign exchange trade, buying the dollar against the euro. Let’s say that one hundred dollars is equal to 77 Euros. The minimum unit you must invest is $10,000. You are going to sell if your investment drops down by $1000. What’s your risk? What’s 1R? We made this example sound complex, but it isn’t. If your minimum investment is $10,000 and you’d sell if it dropped $1000 to $9000, then your initial risk is $1000, and 1R is $1000.
Are you beginning to understand? R represents your initial risk per unit. R is simply the initial risk per share of stock or per futures contract or per minimum investment unit.
However, it’s not your total risk in the position because you might have multiple units. What’s my total risk? Your total risk would be based on your position sizing and how many shares or contracts that you actually buy.
For example, you may buy 100 of the shares in Example 1, which would be 100 multiplied by the share cost of $50 each. So your total COST would be $5000. But you are only willing to risk $10 per share. So $10 multiplied by 100 shares = $1000 total risk for this position.
In example 2, you also buy 100 shares at the $50 price for a total COST of $5000. However, in this scenario you are going to get out if it reaches $48. So your risk is $2 per share multiplied by the 100 shares – you are only risking $200 of your $5000 investment.
Dr. Van Tharp