Dean Whittingham has been a guest blogger here before (see previous posts) and every time he brings great material to our readers and this post is NO DIFFERENT! So please enjoy the article, be sure comment, and also if you have time check out ATradersUniverse.com. ENJOY!
In trading there is a factor known to many as the ‘R’ factor or risk factor. Traders determine their average or base risk per trade they’re willing to take and name it ‘R’, and then measure profits as a multiple of this ‘R’. For example, a 3R profitable trade means the trader has made 3 times the amount they risked. The idea is to determine the ‘R’ factor early on in the trading system building stage and keep it consistent, whether it is a fixed dollar amount or a percentage of available capital.
The benefits of using an ‘R’ factor include measurability, especially during back testing, which helps to determine a systems potential, and being able to track your trades from a systematic point of view rather than a monetary point of view. However it is the monetary point of view that I would like to address as I feel there could be another angle or point of view that could aid struggling traders, especially those that find themselves cutting winning trades short (breaking their systems rules).
First, let’s do a quick demonstration of the use of ‘R’. A trader has $20,000 in capital, and decides he wants to risk $200 of his available capital per trade. After much back testing, he finds that out of 100 trades, 40 were 1R winners, 10 were 3R winners and 50 were 1R losses. He now knows that after 100 trades he system will provide an estimated 20R profit (40R plus 30R minus 50R = 20R), and if ‘R’ is $200, then that equates to $4000. This trader can now use this information to help determine what he needs to do to reach his goals.
Now, when determining the ‘R’ factor, there is one element this trader has missed, and that is, what is his ‘R’ factor from a personal point of view? Why did he choose $200 and not $300 or $100, or some other figure? This in my view is a serious question that needs to be asked and then answered, and in order to do that, one must look at their personal finances and spending habits.
In your every day life you have small, medium and large expenditures all of which fall into the categories of either tangible or intangible. For the most part, most of us have no problems with medium to large tangible expenses, such as house or car payments, or a new TV as these are things we can see or touch. Medium to large intangible expenses are much harder, such as a seminar or course fee where the results are not guaranteed. Small expenses on the other hand are a different breed altogether.
How often will you go and spend money on something small and intangible and think nothing much of the actual expense? An example would be some lunch on the go; where you buy some food and drink and know that the cost won’t change things much for you so you don’t concern yourself with it too much. But let’s say you get home that evening and decide you like the idea of eating out for dinner. Do you now think twice about where you will go and how much you are willing to spend? If so, you have a threshold on the amount of money you are willing to spend (as most of us do), especially on intangible items or items quickly consumed.
This threshold or level of expenditure where you change from not thinking to thinking twice is a perfect example of where your comfort zone currently sits when it comes to the value of money relative to you. Go over it and you get uncomfortable and have to think twice.
In trading, it will be no different. You will find it much easier to take losses where the amount, or ‘R’ factor, is under your threshold, than if it is over. I know many people will respond to this comment with the issue of, by risking so little it will take too long to make any decent amount of money or even the fact that brokerage costs etc will start to become a heavy burden, and these are fair responses. However, the fact of the matter is, the act of trading is not going to change the way your brain responds to such losses because there is nothing to show for the loss (intangible), and if the loss is out of your comfort zone then your brain is not going to like it.
What’s more, imagine you are sitting on a nice paper profit which is in excess of your threshold; an amount that if you were to spend on something intangible would cause you to think twice. Your brain is way out of its comfort zone because a) it’s a lot of money to you, and b) you can’t realize the profit and thus bank it until you actually close out the position! When you are in such a position all sorts of justifications for breaking your rules start flooding your mind.
Both of these instances of not being able to take losses well and cutting winners short are major hurdles traders face all the time and much of the issue lies in their personal relationship to money and the value they place on it. If you have a low relative value of money, it doesn’t matter what the system you use is or how well it performs for others; you are only able to extract from it what your relative value to money is. If you don’t believe me, check out the free e-book and video at this site www.reprogrammingthemind.com and see for yourself on how and why we behave the way we do with money.
You should spend some time assessing your spending habits and determine where your threshold lies. If it is too low to even consider making substantial money in the markets, then you are faced with the tough decision of either looking for a different career or changing your threshold level. Much of the problem lies in the belief that money is something we generally lack, and that there never quite seems to be enough. Unfortunately, it doesn’t matter which way you look at it, this is a fundamental issue for most people, and it is no wonder 95% of trader fail.