R-Multiple Distributions: The Mathematics of Successful Trading
Trading is a game of risk and reward. One's ability to trade successfully ultimately depends on one's ability to manage reward in terms of risk. An R-multiple distribution is a mathematical representation of reward in terms of risk that we can use to objectively examine trading performance and develop more optimal risk management practices.
When entering a trade, we should always have a maximum allowable risk, usually determined by a stop-loss. Suppose we make a trade where R(isk) = $100, which hits our stop-loss, resulting in -1R. We make another trade where R = $100, but this is successful, hitting our profit target of $300. We now have two R-multiples, -1R and 3R, giving us our first, albeit simple, R-multiple distribution. We can compute separate R-multiple distributions for each trader, trading strategy, and trading system.
An R-multiple distribution gives us a wealth of information about our trading. I will discuss three of the most important calculations: Expectancy, Standard Deviation, and System Quality. I would recommend consulting the book Super Trader by Van K. Tharp for anyone interested in a much more advanced treatment of this topic.
When entering a trade, we should always have a maximum allowable risk, usually determined by a stop-loss. Suppose we make a trade where R(isk) = $100, which hits our stop-loss, resulting in -1R. We make another trade where R = $100, but this is successful, hitting our profit target of $300. We now have two R-multiples, -1R and 3R, giving us our first, albeit simple, R-multiple distribution. We can compute separate R-multiple distributions for each trader, trading strategy, and trading system.
An R-multiple distribution gives us a wealth of information about our trading. I will discuss three of the most important calculations: Expectancy, Standard Deviation, and System Quality. I would recommend consulting the book Super Trader by Van K. Tharp for anyone interested in a much more advanced treatment of this topic.