A Question About Percentage Returns

Mike, I'd prefer to think in terms of absolute return; if you double your equity in a year, how can anyone say that you only make 25%? People/hedge funds who trade options of futures usually take advantage of huge leverage to achieve their objectives; if they double their equity in a period of time, I doubt if they'd claim that they only make 25% since they have to take 4x leverage into consideration!

In my opinion, no matter what kind of leverage you use, only the final and absolute result counts. One can't really say that, since you use 4x leverage, you don't actually achieve 100% profit - it'd be nonsense, since you know the real profit is there, in your account. Leverage wouldn't help at all without the skills to accompany it. After all, if one's account got wiped out with 4x leverage, could he really say that he only lost 25% of his equity, since he'd used 4x leverage?

Hey Mike,

Do you trade all of your capital? Or do you portion it out - say the minority of your capital in short term trading and the majority of it in a long term stock/property investment?

I also want to ask you what your opinion is about this: Is it worth actively trading or simply sitting on a great company giving great returns? I want to refer you to an old blog entry I had, just stating how much an investor would earn - had they invested in the right stocks.

I can't believe anyone would honestly call turning 100K into 200K a 25% gain because you started out with 400K of buying power. After all, your buying power doubles as well.

Ken & Dave,

I agree with both of you. That's certainly how I look at it. And the point about hedge funds using a ton of leverage is a gret point.

Marco - I guess I'd say trade with all of my capital. I use my IRA for longer term plays. About your blog entry, my answer is "it depends". It's easy to answer that in hindsight (buy & hope, er, I mean hold, don't trade) but how many stocks are going to move like that? How many people are going to catch that kind of move and be able to hang on for the entire ride?

I've had a couple of 10-baggers in my long term account before and I'm looking forward to my next one(s).

Why not standardize R against a unit value? Otherwise, for all the talk about R, you still must refer back to % return for the big picture.

This is one thing that confuses me when it comes to your R value and equity and margin, this probably confuses me because I have no experience with margin accounts.

So say you have 100k equity(your cash) and 4x buying power from the margin account. Say your R value is 1%, so you risk 1% on every trade. are you risking 1k or 4k?

The real question is this. If a trader has a $25,000 (using 4X), and loses 20 grand, does he tell his wife he is only down 20% because of the increased leverage? Or does he tell the truth, and admit he blew out 80%?

Dan, in that example 1R would equal $1,000. R is expressed as a percentage of my account's equity.

John, yes, that really cuts to the heart of the matter! :-)

Mike, please help me undertand this. You said:

"If my R was equal to 1% of my account I would have made 168% in those same 9 months with the same trades."

Now, as far as I understand this concept, R = risk, which means the maximum amount you care to lose on a single trade with respect to your total equity:

R% = Total Equity / X * 100

If that is the case, then how can your above statement be true? If your R was 0.5% and you made R100 over whatever period of time, then it cannot be determined what your R multiple would have been if you increased R to 1%. It may have resulted in less profit.

Correct me if I am wrong, but isn't the only difference between any two values of R is where you place your stop? If so, how can you say that placing your stop further away would have resulted in proportionately higher profits? Yes, some trades would have a better chance for reversal, but others would just end up losing that much more money.

Jocko,

Let's say I was risking $500 per trade and my stop, which is always determined by a logical point on the chart, was $1 away from my entry. Because of the way I size my positions I could buy 500 shares. If I increased my risk (R) to $1,000 for that same trade with the same stop I could buy 1,000 shares. So my gains/losses in trade 2 would be double that of trade 1.

Oh, OK, if that is the case, then....we're almost there.

1. Does R automatically imply that the stop order is fixed and only the amount traded is increased? But where o where is that ideal stop point? That would likely change from stock to stock and many times via experimentation.

2. In practical terms, according to that basis, R multiple would proportinately increase, theoretically. Technically, the other thing to consider is the extra amount lost for every bad trade. That magnifies itself when the loss:profit ratio of trades is high.

I'm not trying to argue here (debate perhaps), but this R concept, to me, still appears to be more abstract than need be.

I don't think it's abstract at all. It's simply the amount at risk per trade. That combined with the stop tells me my position size.

1.) No, R doesn't imply that... my position sizing model implies that. Somebody else with a different style could very well move their stop to adjust their dollar risk per trade. That's not how I do it though and I was just speaking for myself. The ideal stop point is determined by looking at support for longs and resistance for shorts. It certainly does change per stock and per trade.

2.) See, this is why I like to use R multiples. If I told you that I made 100R, that is 100 times my risk per trade, then it doesn't matter what R is, you have an idea of how good my sytem was.

So let's take two cases, the first with R = $100 and the second with R equal to $1,000. Both systems had 120R of winning trades and 20R of losses after a year. So system 1 had $12,000 in gains and $2,000 in losses for a total of $10,000 in profit or 100R (100* $100) in profit.

System 2 had $120,000 in gains and $20,000 in losses for a total of $100,000 in profit or 100R (100* $1,000) in profit.

Sure the losses were bigger in system 2 but so were the gains. Net result is that they both made 100 times their risk per trade.

To me, R (and expectancy) tells you how efficient your system is. Once you know that you have a positive expectancy system all you have to do to make more money is increase your position size. Of course that assumes that your system continues to work and that you don't size your positions so large that a string of losses will wipe you out.

Mike, in theory I'm not diagreeing with the concept. There have been many brains before me that have adopted this concept. So, who am I to argue. I'm just saying that, to me, it is more abstract than need be.

I hear you though. But, to me, I think it is common sense that your position size will increase with your total equity size. But, it comes down to selecting the right vehicles in the right market.

Just using the R concept alone can be deceiving, I think. Would it be beneficial to use this concept on a $30 stock once your total equity has increased to $300,000?

Let's say your R = 1% and its a $30 stock:

1. 1% of $30,000 = $300
A) Stop = 30 cents = 1000 shares = 100% equity
B) Stop = 15 cents = 2000 shares = 200% equity
C) Stop = 10 cents = 3000 shares = 300% equity

2. 1% of $300,000 = $3000
A) Stop = 30 cents = 1000 shares = 10% equity
B) Stop = 15 cents = 2000 shares = 20% equity
C) Stop = 10 cents = 3000 shares = 30% equity

E) Stop = 30 cents = 10,000 shares = 10% equity
F) Stop = 15 cents = 20,000 shares = 20% equity
G) Stop = 10 cents = 30,000 shares = 30% equity

A) Stop = $3.00 = 1000 shares = 10% equity
B) Stop = $1.50 = 2000 shares = 20% equity
C) Stop = $1.00 = 3000 shares = 30% equity

With $30,000 in total equity, a $30 stock would be a reasonable vehicle to trade. But, with $300,000, either the stop would have to be moved or the position size would have to increase dramatically, neither a good option. Wouldn't a different choice of vehicle be better, such as a more expensive stock in this case?

My point is, I see that by using this R concept, there are many other factors to consider. OTOH, common sense would (or at least should) consider most of these factors a bit easier and quicker, which is why I say the R concept is abstract.

BUT, if it works for you, then its a great concept. Whatever works and helps you make more money will always be a great concept. Howeer, I don't know if any concept is best for everybody.

Mike: If I can make at least 20-25% a year, I'm happy...If I make more, I'm happier....

Jocko,

Of course it makes sense that your position size will increase along with your equity but that isn't what you asked nor what I was describing. What I was saying is that if my risk per trade (and therefore my position size) was larger with the same equity then my profits would have been larger.

I think you're making too much out of this. Anybody with any sense would only trade stocks that have enough liquidity for their desired position size. As I've said before on the site, to me the percent risk position sizing model makes most sense for day trading because of the 4x margin. I'd NEVER use it for any stock that I held overnight. So having said that, why is it a problem to have 100% of your equity in one stock for a day trade? As long as your risk is controlled and the stock has enough liquidity it shouldn't be a problem.

You lost me with your second example. What point are you trying to make with E, F, and G?

I'm not sure what you're getting at with that second example. Are you saying that it would be better to trade higher dollar stocks because you'd put more money to work? If so, I don't agree. The question is which stock has the potential to move more on a percentage basis. If there's a $30 stock that's on fire today vs. a $70 stock that's just chopping around in a $1 range, I'm gonna trade the $30 stock, no matter what my account size is. The more volatile stock could easily make me a greater profit vs. the higher dollar stock -- the price of the stock doesn't matter.

Once again, I never said that anything I do is best for anybody else. Nor have I encouraged anybody to do anything that I do.

I'm not saying that 100% or more of your equity in one stock is a bad thing. In fact, that is what I most often do. I generally maximize my daytrading buying power. What I AM saying is that the R concept is abstract in that it leaves out other factors. In this case (in my example), yes, I am saying that one would have to (or should according to the R concept) enter into higher priced stocks with higher total equity.

Sure, trade those $30 stocks. I do if they are volatile and liquid. I'm just saying that it doesn't fit the mold of the R concept. You're not going to daytrade 20 or 30,000 shares at one time, are you? That's the point I was trying to make with my two examples (Example 2 should be A-J). With the R concept and a low priced stock, you'd end up trading a ridiculous amount of shares, not take advantage of your daytrade buying power, or end up expanding R. The last two are OK, but neither would satisfy the R concept.

This is why I say that the R concept is abstract and incomplete. In order to satisfy it as your equity grows, you would have to play proportionately higher priced stocks. Otherwise, you'd defeat the concept by not maximizing your BP and/or expanding R.

As I said, I don't disagree with the concept. I think it is a decent concept for beginners (albeit more abstract than necessary, IMO). But, it breaks down over time. Statistics should remain consistent throughout. My example shows that the R concept can only remain consistent if you adjust your trading vehicles to conform to it.

Now, personally, I do think that it is wise to focus on more expensive stocks, anytime, especially with higher total equity, but, not to do so just to conform to a statistic.

Nevertheless, as I said, whatever works for you is great for you. And, although it may appear that I am making too much out of this, I am only trying to make my point, which can be taken or left.

So, on to the next topic.

You're trying to make "the R concept" something that it is not. All R is is your dollar risk per trade. How somebody sizes their positions, picks stocks, places their initial stop has may very well be independent of what their R is.

No, I'm probably not going to daytrade 20,000 or 30,000 shares of a stock. When did I ever say that I was going to? Even now I regularly find entries with stops so tight that they require me to trade what I consider to be too many shares. In those cases I'll either cut my position size, make the stop wider (thereby decreasing the number of shares I would trade) or skip the trade all together.

The problem of trading to many shares as your account becomes very large will happen with ANY position sizing model. That's when tactics would have to be canged somehow. (trading different vehicles, using a portion of your equity for different strategies, etc.) That isn't unique to "the R concept"

One thing that we can agree upon is that this horse has been beaten to death.