It’s not always easy to figure out exactly how someone else interprets trading knowledge and whether they truly understand the implications of it. Sometimes it takes a chance conversation in order to pick apart just how differently your own interpretation may be.
This week I was lucky enough to have such a conversation and a huge trading mistake became apparent.
Risk in terms of R
The way risk is handled by Van Tharp, as I’m sure many of you will already know, is by expectancy. Expectancy is basically your average trade in terms of your initial risk. So if your initial risk on a trade is $500 and the trade goes on to make $1,000, the trade is said to have made a 2R profit. If initial risk is $300 and you lose $450, you’ve lost 1.5R.
The way I see this is that it’s a very good way to compare the quality of trades where the specific $ amounts don’t always align particularly well and it gives you a better idea of what you should expect to make or lose on each trade you take. In my opinion, this analysis is particularly well-suited to people trading across a broader range of products such as a portfolio of stocks and this is how my chance conversation began.
Comparing apples with apples
My friend and I were talking about his stock trading and he was eager for me to take a look at his portfolio so he could show me what he’d been doing. As he ran through his different open positions, of which there were around 50, I struggled to get an idea of how good each trade really was – and that’s when I asked him about whether he uses expectancy.
He said that he didn’t know about expectancy and asked me to explain it. After a basic explanation, I set about pulling in his trade data to do a quick demonstration of expectancy for him, but as I started to break things down, something concerned me greatly.
Not defining risk before taking a trade
“So what’s your initial risk for this trade?” I asked. “Well I don’t really have one.” He replied. “Well where would you be wrong?” I pushed, wide-eyed.
The conversation continued in this manner for a while, with me trying to get to the bottom of what he thought of as risk. “So if you don’t have a stop, you’d let this stock go to zero?” I asked. “Well yeah, but it’s a great stock!”
Incredible. Not only did he not define his risk, but what eventually became apparent was that he felt that only going for trades with “at least a 2:1 R:R” adequately covered it. Again, I’m wide-eyed at this point.
R:R vs. Risk
What R:R does do in combination with win rate, is define whether or not an opportunity is worth taking or not. It doesn’t tell you the value of your initial risk in isolation. It tells you the ratio of what you make when a trade works to what you lose when a trade doesn’t work. But it might be enough to figure out what your initial risk is so long as you identify the other side of the equation – what your profit target will be.
Account equity risk vs. Market risk
To quote a very famous and successful trader: –
“Losers average losers”
– Paul Tudor Jones.
This wisdom seems pretty obvious on the face of it, but let’s think in terms of my friend and his stock portfolio trades once again.
There are two types of entry risk you can take – one is information risk the other is price risk. Many people struggle to find the right balance even if they understand the principles at work. But there are also two types of trade risk people take – one is account equity risk and the other is market behavior risk. Account equity risk is risk relative to the capital in your account and it’s all about staying in the game long enough to make your trading edge pay. Market behavior risk is the risk that a market will change behavior and the probability of price moving significantly against your position.
Both must be accounted for. However, like my friend, most people tend to only focus on account equity risk.
It turns out that my friend “improves the average price” of his trades as the market moves against him. He’s basically taking longer term views and trading around his position (not simply adding all the way down). So account equity risk is clearly something he’s trying to factor in. In fact, I see nothing wrong with a skilled trader doing this. UNLESS they do not take into account that there’s a point when the market changes in behavior and demonstrates that the trade is probably wrong. This is market behavior risk. In reality, it’s best defined by a combination of a threshold technical price level and a shift in behavior on a breach of this price.
My friend accounted for neither.
Trade the market against itself
The true wisdom in what Jones was saying is this: when a trade is a loser (not just off side) you shouldn’t still be looking to take positions in the same direction. Many traders look at a market in a way that is totally skewed towards their own interaction with it rather than based on a market’s own action. More precisely, some traders trade in $ and not in market price.
True, the markets are a sum of their participants’ behavior. However, it’s highly unlikely that a market is going to flip its current behavior just because Joe Bloggs hits a 10 tick stop. But it might just change if it breaks a key technical price level for example – and it’s at this point that it’s probably not wise to hold or add to your original position.
Excellence in trading comes in part from understanding that it’s critical to marry the ideas of risk and create a strategy that encompasses both account equity risk and market behavior risk. If you don’t make it your business to do this, you’ll also make this huge trading mistake.
For more updates from Mark and the team at NetPicks, be sure to visit their trading tips blog at NetPicks.com.