Trading Defining “R”

This week’s article, I want to focus on Van Tharp’s “R” from his investment book, Trade Your Way to Financial Freedom. Thanks to understanding “R”, I can honestly say I’ve been more profitable and on the path to becoming a far more consistent day trader.

What is “R” and How is it Used?

R is simply the dollar $ risk per trade. It is another way of looking at a profit vs loss ratio.

Example 1

Let’s say for example you buy 100 shares of stock at $100 per share, so total investment $10,000. If you define your cut off point at $97 and set a stop loss order accordingly, 1R is $3 and your total Risk $ is then $300 (100 shares x $3 per share).

If the stock trades down to $97 and you are subsequently stopped out of the position, your net loss is -1R (-$300). Alternatively, let’s say the stock moves up to $106 and then you sell for a +$600 profit, that would be a +2R winner.

Example 2

Now, let’s say you bought 10,000 shares of the same stocks at $100 per share. Using the same $97 Stop, your risk is $30,000 instead of $300, however it is still 1R.

By translating each trade into R terms, you open yourself to a new state of mind and your ability to manage positions becomes far more effective.

Position Sizing Magic Using R

By thinking in terms of R and calculating it with each trade, you can quickly and easily define risk for each trade. Furthermore, you will realize that despite trading roughly the same amount each time, your trades have been terribly inconsistent.

Let me explain.

Let’s assume you put roughly the same amount of money in each trade. For these examples, we will use $10,000 to keep things simple.

As an example, Apple (AAPL) trading at $467.68, which would buy us a nice even 20 shares with our $10k. If we determine our stop to be $460, our total risk would be $153.60 (20 shares x $7.68). $7.68 is our initial 1R.

At the same time, we also determine Netflix (NFLX) to be a strong buy candidate, which is trading at $302 even. Trading the same $10,000, we can buy an even 30 shares (avoid odd sizes, ie 43 or 67, whenever possible). Let’s say we feel $300 is key support, so we set our stop at $299, thus our total risk is $90 (30 shares x $3). $3 is our initial 1R.

This is where it gets interesting.

Let’s say both stocks run 5% higher and we sell to lock in a profit. Our Apple trade would yield us $467.68 in profit (20 x $23.38), and our Netflix trade would return us $453 (30 * $15.1) in profit.

$467.68 (AAPL) and $453 (NFLX), both roughly 5% profits off each initial $10,000 investment. Great right? No problems here.

Wrong.

The difference is that with Apple we risked $153.60 to make $467.68, so using R our return is +3R, whereas with Netflix, since we took less risk ($90), our return is actually +5R. A huge difference of 60%+!

Now imagine making 100s of trades over xx years without using R vs using R. You can quickly figure out that your returns would differ dramatically.

By defining risk using R, a completely different story is told under the surface. Not only can you manage positions equally (risking the same amount $ on each trade), but you can tweak your strategies to focus on higher Risk / Reward trades moving forward.

“R” is a Tool to Limit Risk

Many, many, many successful traders over the years talk about limiting risk as one of the critical keys to long term success with day trading:

“At the end of the day, the most important thing is how good you are at risk control. Ninety-percent of any great trader is going to be the risk control.” – Paul Tudor Jones

“The elements of good trading are: 1. Cutting losses, 2. Cutting losses, and 3. Cutting losses. If you can follow these three rules, you may have a chance.” – Ed Seykota

“The golden rule of trading is to keep losses at a level of 1 R as often as possible and to make profits that are high-R multiples.” Van Tharp

By defining R with each trade, you have the power to quickly determine not only what your R value is for winners, but also losers.

Look at your losers and see if you have ever lost more than -1R (your original risk). More than likely you have. The question is how much more and why.

It is common to experience slippage and have orders executed lower than the preset stop. This is especially true for those trading larger position sizes. So, a -1.1R might be common. But, if you are seeing -2R, -3R, or heaven forbid -4R losses or more, you have identified a serious flaw in your trading. You can’t cut your losses!

Create a new column in your excel sheet Trader Worksheet right next to your % return column so you can see the R result to quickly analyze past R values. Then, average them together to determine your average R.

It is inevitable that you will have losses over -1R or less than -1R. But they should never average out to anything below -1R. If they do, you have one big hole in your trading, which is a good thing, because it means you have room for improvement.

Just like the most successful day traders of our time, you too can cut your losses short, and by using R, you can quickly determine how well your efforts have panned out. Do it!

Determining Strategy Success Using “R”

The last piece of calculating R is determining the overall success or failure of any given trading strategy.

With all your trades logged away and organized by strategy, you can quickly determine the real results. Take all your R returns, sum them up, and you will have your net R return for that given strategy or group of trades.

If it is positive, congratulations. If it is negative, congratulations as well, you have an opportunity to make a change right now today and improve as a day trader.

Whether you are a day trader or a long-term investor, the end goal is always the same: return maximum R in the shortest amount of time.

You might think that your long-term strategy that yields a 100% return, a +10R winner, is your best. However, if each +10R winner takes you on average 3 three years to achieve, you may find that your shorter term trading strategy which yields one +30%, +3R winner every 6 months is more successful and a better place to focus your energy.

Remember, the R $ dollar value is ultimately irrelevant once it is equalized for each trade. If your R is $100 for every trade you make, then you can use R to quickly calculate success. +30R over 20 trades means a +$3,000 return, and so on.

Day Trading is about long term sustainability. Learning to always calculate and think in terms of R is a great step towards getting there.

Conclusion

In conclusion, “R” can be broken down as follows:

  • R is total $ risk. If you buy 100 shares of a $100 stock and your stop is $99, then your initial risk is $100 (100 shares x $1) and 1R equals $1 ($100 purchase – $99 stop).
  • By calculating R for each trade, you will learn that the total $ amount invested in each trade does not matter, it is total amount $ risked (initial R) that matters.
  • No two trades are equal unless they have the same initial R value. A +$500, +5% profit as a +5R return is far better than a +$500, +5% profit as a +1R return simply because there was far less risk required to achieve the result.
  • To determine success of a strategy or group of trades, determine the net R for each trade then sum them together. Average your losers together to ensure you are always cutting losses short.
  • Using R is one big key towards long term sustainable, successful day trading.

Still interested in understanding more when it comes to successful day trading defining risk as “R”? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to becoming a consistently profitable trader! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Money Mistakes

According to marriage.com, money is one of the top reasons couples cite when filing for divorce. Money and investments are emotionally tense – after all, although money can’t buy happiness, it does make the world go around and give you choices. With the recent stock market volatility, and all the emotion’s volatility evokes, I thought it might be time to confess that even professionals experience moments of uncertainty. Below are a few times I had to rely on my training to overcome my emotional bias towards making some common financial mistakes.

1) Making asset allocation decisions based on current market conditions. Although my children might argue otherwise (my youngest has drawn pictures of me, thoughtfully including my many forehead wrinkles!), my wife and I are relatively young. We won’t be tapping into our retirement accounts for at least another 25 years. With such a long investment time horizon, we should be invested entirely in equities. And yet, as the market continued to climb to new heights, I started to question if perhaps we should “take some gains off the table.” This is not uncommon – behavioral finance researchers have found that the emotional pain of losing $1 is far greater than the joy derived from gaining $1 – so we are wired to try to protect our gains. Although it would be painful to see the value of our investments halved (as happened from the peak in November 2007 to the bottom in March 2009), because we don’t need to tap those assets for at least 25 years, we chose to maintain our current asset allocation strategy, and will modestly reduce our exposure to equities as we get closer to retirement.

2) Negatively arbitraging our assets. For clients who are still working, we recommend keeping roughly 3-6 months’ worth of expenses liquid – in a savings account, or money market fund – to be tapped for emergencies. Funds above and beyond that amount can be invested (example: real estate) or used to pay down debt. And yet, I took great comfort in seeing our savings account balances grow beyond our emergency fund, even though we were only earning 1.5% on our savings. Having a large cash balance provided me with comfort but didn’t make sense. We decided to put the additional funds toward buying more real estate.

3) Being underinsured. I will never forget the absolute terror I felt when I was out of state meeting with other business leaders, and my phone rang, with Grand Strand Medical Center coming up on the caller ID. Worst case scenarios flashed through my mind; I was terrified I was a widower with two boys at 41. Now, my wife was fine, and I will not bore you with the details. Yet, even though we were at that time eligible to apply for life insurance coverage, we just…didn’t. We knew it was important to be insured in the same nebulous way we knew we should eat less sugar, but never felt compelled to action. Not until I sat in a client meeting and seen that the clients were underinsured. The young, beautiful wife laughed, and said they would be getting a quote for insurance the next day, because if anything happened to her husband, she didn’t want to be looking for her next husband at her first husband’s funeral. I left work that day, and by the next morning my wife and I had both applied for life insurance.

Conclusion

It’s easy to be emotional, or complacent about money – I’ve been there. In working with our clients, we try to point out places where improvements could be made, while managing the complex emotions and attachments we have to our money and investments.

Still interested in understanding more when it comes to making money mistakes? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to making money mistakes and learning from our experiences! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Keep an Eye on Inflation

In October 1968, with the United States fighting wars against poverty at home and perceived communist threats abroad, the S&P 500 Index climbed on the back of an overheated economy to record highs in both real and nominal terms. The boom times were not to last. Adjusted for inflation, stocks would not return to their late 1968 levels until mid-1992 (chart data). In nominal terms, full recovery took about seven years from a January 1973 peak.

I offer this cautionary tale by way of explaining why recent decades have differed so dramatically for equity market investors from those generally unprofitable years a generation or two ago. Unlike current conditions, what characterized the period beginning in the late 1960’s were cost of living increases that compelled President Richard Nixon to impose wage and price controls and the Federal Reserve to raise interest rates to levels that today would seem unfathomable.

At the vanguard of the Fed’s anti-inflation effort was the late Paul Volcker, the central bank’s chairman from 1979-1987. Volcker allowed benchmark rates to reach nearly 20%, but his tough love approach to price stability is widely credited with subduing inflationary expectations and thus sowing the seeds for the long economic expansions and bull markets to follow.

So, while recessions are the most obvious and direct causes of severe market declines, it’s rising inflation that triggers economic downturns by motivating the Fed to take away the monetary punchbowl. Of course, recessions cause corporate profits to fall as well, but earnings are only half the story. The other half concerns the impact of rates on valuations.

Historically, the equity market’s price-earnings ratio has moved inversely to bond yields as money flowed out of stocks and into higher-yielding assets. Viewed another way, the equity market’s earnings yield – its P/E ratio expressed as a percent – closely tracked the yield on Treasury bonds. (A P/E ratio of 20 equals an earning yield of 5%, or 1.00/20=0.05)

Which brings our story to the outlook for stocks in the months ahead.

Among the enduring mysteries of what’s become the longest expansion on record is the breakdown in the relationship between unemployment and inflation, also known as the Phillips Curve. In the past, tight labor markets have fueled fast-rising wages and benefits, which in turn fed through to consumer prices and finally to higher interest rates. This time, not so much. Despite the lowest jobless rate since the boom days of the late 1960’s, inflation has consistently undershot the Fed’s 2% target, as measured by the central bank’s preferred metric, the Core Personal Consumption Expenditures Price Index. That’s allowed rates to stay low by historical standards, thus extending the bull market in stocks.

Some economists believe the recent failure of the Phillips Curve to explain inflation can be attributed to a changed definition of full employment while others think a myriad of complex global factors are at work.

Conclusion

What matters most for investors, however, is that inflation expectations remain anchored and that core inflation stays at or below the Fed’s 2% target. Until that changes, we aren’t likely to find the Fed’s fingerprints on whatever weapon eventually brings about the demise of the longest bull market in U.S. history.

Still interested in understanding more when it comes to inflation? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to what’s ahead for stocks and inflation! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Bonus websites of interest…

Economic Conditions Trend And Outlook For 2020

Economic Growth Slowed in 2019 Q3

As the U.S.-China tariff war escalated in 2019 and investors became more concerned about the economy’s long-term prospects, GDP growth slowed to 2.1% in 2019 Q3. Private investment spending contracted for the second straight quarter by 1% as non-residential investment spending dropped by 2.3%, although residential investment spending rose 4.6%, buoyed by low mortgage rates. The pullback in business spending as somewhat offset by the expansion in private consumer spending that rose 3.2%, amid strong job growth. Net exports rose a modest 1% after contracting in the prior quarter, while imports increased 2% after a flat growth in the prior quarter. Government spending rose 4.8% due to the strong growth in federal spending of 8.3%.

Sustained Job Creation in 2019

Job creation remained strong in 2019, with 2.1 million net new payroll jobs created as of December 2019 compared to one year ago. Payroll jobs rose in all sectors except in utilities and mining/logging. The retail trade industry, which had been losing jobs in past months, created net new jobs (15,300). The construction industry created 143,000 net new jobs, although this is about half of the 342,000 annual jobs created in January 2019. The unemployment rate dipped to 3.5%, at par with 50 years ago. The number of 16+ year-old unemployed workers trended downwards to 5.75 million, near the level in 2000 (5.69 million).

Economic Conditions

Nonfarm payroll jobs increased in all states, except Wyoming, Oklahoma, and West Virginia. The states with the strongest job growth were Utah (3.0%), Texas (2.7%), Nevada (2.7%), Idaho (2.6%), Washington (2.5%), Florida (2.5%), Alabama (2.4%), Arizona (2.4%), Rhode Island (2.2%), and Colorado (2.1%).

Wage Growth Tapers as Inflation Picks Up

Even as the unemployment rate continues to fall, average weekly wage growth has tapered. In December 2019, average weekly rose 2.3% from one year ago, about the same pace as the inflation rate. Wages have been rising at slower pace since January 2019 while inflation has picked up, resulting in no real wage gains for workers. Meanwhile, CPI-Shelter, an indicator for the price of housing services (e.g., rent) rose 3.2%. Rent growth has generally outpaced inflation and wage growth since 2012, an indication that housing supply remains low relative to demand. Average weekly wages rose in all states, except in Wyoming, Ohio, Alaska, and Texas (this may just be a statistical fluke given Texas’ strong job growth.

Yield Curve Normalized in November 2019

The Federal Open Market Committee lowered the federal funds rate three times in 2019 by a total of 0.75%, to the current range of 1.5% to 1.75%. The yield curve normalized in November 2019 after it inverted in January 2019 when the 5-year T-note yield fell below the 1-yr T-bill rate.

Macroeconomic Outlook Conclusion

We expect GDP growth to pick up to 2.4% in 2020 given the de-escalation of trade tensions between the United States and China, starting with the signing of the Phase One Trade Deal in January 2020. We view this development as having a positive impact on investor confidence and rising business investment. Unemployment rate will further ease to 3.6%.

The Federal Open Market Committee to likely maintain the federal funds rate at the current range of 1.5% to 1.75%. Under an accommodating monetary policy, the 30-year fixed contract mortgage rate is expected to stay below 4%, which will support 5.5 million of existing home sales and 0.75 million of new home sales. Low interest rates will keep debt financing for new home construction low, encouraging the production of more homes. As builders continue to see strong demand for both owner-occupied homes and rentals, we expect builders to increase construction of new housing to 1.37 million, of which 415,000 (30%) will be multi-family units.

Still interested in understanding more when it comes to today’s economic conditions? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to the macro-economics in this global landscape! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Classic Advice on When to Sell

I figured it seems fitting to write this article in the market environment in which we find ourselves today.

“If the job has been correctly done when a common stock is purchased, the time to sell it is — almost never.” — Philip A. Fisher, Common Stocks and Uncommon Profits, 1958

With the major market indices continuing to reach new highs, some investors are wondering if they should sell their stocks. After all, if prices are high & the holdings have been profitable, why not sell & take the gains?

On Wall Street, the preference to sell can be especially popular. Many brokerage & research firms publish price targets for stocks & recommend selling them once the target has been reached. Other firms routinely recommend moving to all-cash positions based on market, macroeconomic or geopolitical forecasts. Still others view stocks as little more than trading vehicles & move in/out many times over the course of a month, week, day or microsecond, as in the case of high-frequency traders.

At the other end of the spectrum are investors who never sell at all. In an article published in 1984, author Robert Kirby described a situation where his purchase recommendations were followed, but his sell recommendations were ignored. After many years, the result was an odd assortment of small holdings, several large holdings, & one huge holding of Haloid which later turned into a zillion shares of Xerox. Kirby, of course, had recommended that Haloid be sold.

In our investment club, our analytical work focuses on the underlying businesses of the stocks. We think of our club as part-owners of those businesses &, as long-term investors, our club owns the shares for as long as the company’s management team is doing its job to increase shareholder value. Given enough time, a company’s share price is likely to increase along with growth in its revenues, earnings, & dividends.

However, companies can change & industries evolve, & management teams can lose their way. Sometimes better opportunities develop elsewhere.

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.” — Benjamin Graham, The Intelligent Investor, 1949

Conclusion

At the end of the day, investors are well-served if the job of analyzing a company includes a thorough review of its underlying business & fundamental characteristics — this holds true for selling & buying. If the company selected for purchase passes criteria on all counts, it could be a long time before it needs to be sold. And selling a high-quality, adeptly managed company just to take profits rarely is a viable long-term investment strategy.

Still interested in understanding more when it comes to selling a stock investment? If so, contact our Firm at 843-945-0051 and someone will be able to explain more in depth of what you need to know when it comes to stock market investing! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries