Who is Van Tharp?
Van Tharp is a Dr of psychology and has long been considered one of the leading minds regarding trading psychology, focusing on the use of NLP.
Van Tharp developed the R-Value/Multiples concept back in the ’90s and it featured in his 1998 book ‘Trade your way to Financial Freedom’.
Although the original book is over 20 years old, the concepts Van Tharp discusses are as relevant today as they were upon its initial release.
What does R mean?
R = Risk. The R-Value model is linked to the value of the risk of each trade. Regardless of position size, the SL will always be -1R. The R-Value of each trade is a multiple of the max risk of the trade.
Let’s explain further.
You place a long entry on EURUSD at 1.1900. The SL goes at 1.1850. In this case, the distance between the entry and the SL, 50 pips, equals -1R. If you instead place the SL at 1.1800, some 100 pips away from the entry, this still equals -1R.
Notice that this calculation is done regardless of position size. It’s important to note here that you should always consider the rules that govern the placement of an SL during the strategy development process.
These rules allow for consistency between trade and risk evaluation and improve the robustness of your optimisation process.
So with the R calculated, you can then calculate the position size. Using the above two SL placements in this example.
If you want each trade to carry the same risk on the equity, you would need to make the trade with a 100 pip SL half that of the trade with the 50 pip SL. Each trade would then carry the same risk on the account. If you’re not familiar with pips and lot sizing, you can read more about them here.
Now that each trade carries the same risk, usually around the 1% mark, this is up to you, however. With each trade now having the same risk, any returns generated can be easily compared and quantified.
So what would the R of a positive trade be?
Suppose the trade has a 50 pip SL and hits a TP of 100 pips the R=2. To calculate the R, you simply divide the positive return by the size of the risk, in this case, 100/50=2R.
If the trade with a 100 pip SL hits a TP at 100 pips, the R of this trade would only be 1R despite moving an equal distance (remember, a pip is only a measure of the distance of price).
By calculating these values in this manner, you significantly improve the statistical significance of your optimisation processes by comparing strategies using an equal risk approach.
By doing this, you can compare a system that trades on the 5min timeframe with a strategy on the daily timeframe. The 5min strategy may have a five pip SL, whereas the daily may have a 100 pip SL. By measuring each trade in R-Multiples, you can accurately compare the two.
When analysing any set of data, you need to consider the size of your data set. Using a small number of trades in a backtest to base a trading decision on is reckless. You should give serious consideration to the number of trades used. Think thousands over tens.
Darwinex created 12 Investible Attributes to help traders and investors alike analyse the trading data of Darwins. One pair of Investible Attributes that are beneficial to visualise what R-Multiples can look like in a live account and what benefit you can gain from them is the R+/R- IA.
Under the Investible Attributes tab, you can see all the investible attributes for each Darwin. In the middle, you can see the R+/R- IA. The R+/R- IA shows the returns distribution in pips.
If on the left, on the negative return side, most trades are clustered around the same negative value; this can indicate that the trading account uses the same size SL for all trades.
You can then quickly eye the average positive return distribution and get a sense of the average R-Multiple of the Darwin.
Do you use Darwinex’s Investible Attributes to help inform trading decisions? We’d love to hear how. Get in touch on Twitter @Darwinexchange
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Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.