Every Trading System Can Be Described By the R-multiples It Generates
Last week I talked about determine your initial risk for each trade and how you could express your profit and losses as a ratio of that initial risk. I recommended that you always have a bail-out point before you enter into a trade, but if you haven't done that then you can look at old trading results and use your average loss as an estimate of your initial risk.
I then gave you an assignment to determine the R-multiples for your trading over the last 12 months. Furthermore, I gave you a sample of data shown in the table below.
In the table we have three losses $567, $1333, and $454. The average loss is $785.67, so we'll assume that this was the initial risk. Hopefully, you'll know the initial risk, so you won't have to use the average loss. I call the ratios that we calculate, the R-multiples for the trading system. This information is shown in the table below.
||Profit or Loss
When you have a complete R-multiple distribution for your trading system, there are a lot of things you can do with it. First you can calculate the mean R-multiple. The mean R-multiple is what I call expectancy and it tell you what you can expect from your system on the average over many trades in terms of R.
Although I recommend that you have a minimum of 30 trades before you attempt to determine the characteristics of the R-multiples, because these are short tips, we'll just use the eight examples in the table. Here the mean R-multiple 0.68R. What does this tell you?
The expectancy tells you that on the average you'll make 0.68R per trade. Thus, over 100 trades, you'd make about 68R.
The standard deviation tells you how much variability you can expect from your system's performance. In the sample our standard deviation was 1.86R. Typically you can tell how good your system is by the ratio of the expectancy to the standard deviation. In our small sample, the ratio is 0.36, which is excellent. After a 100 or so trades, I'd expect this ratio to be much smaller, but if it remains above 0.25, we have a superb system. But that's another story.
Van K. Tharp, Ph.D.
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