By ProfessionalTradingSystems.com
Each trade has two components – a final result measured in pips (1 pip = 0.0001) and an initial risk measured again in pips. In long positions, the end result is the exit price minus the entry price and the initial risk is the entry point minus the Stop Loss level.
Example 1 – We have a buy order at 1.2366 with a Stop Loss at 1.2286, which is exactly 80 pips of risk (1.2366–1.2286). The trade is closed at a price 1.2486. The end result is 120 pips (1.2486-1.2366).
In short positions, the end result is the entry point minus the exit point, and the risk is the value of the Stop Loss minus the entry point.
Example 2 – We have a sell order at 1.2266 with a Stop Loss at 1.2386, which is exactly 120 pips of risk (1.2386–1.2256). The trade is closed at a price 1.2186. The end result is 80 pips (1.2256-1.2176).
We call the ratio end result/initial risk as R-multiple or only R. We measure each trade in R.
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From example 1, we have 120/80=1.5R.
From example 2, we have 80/120= 0.66R.
Why do we do this? Because it is important for us to know how much in percentage terms our capital is increased as a result of a trade. Knowing the result in R, we quickly convert R in percentages.
If we assume that we risk 1% of our capital in the trade from Example 1 and 2, then we have following:
Example 1 – 1.5R*1%= 1.5%. This means that after this trade, our account have increased by 1.5%.
Example 2 – 0.66R*1%= 0.6%. This means that after this trade, our account have increased by 0.66%.
If we assume that we risk 2% per trade, then from Example 1 and 2 we have:
Example 1 – 1.R*2%= 3%. This means that after this trade, our account is up by 3%.
Example 2 – 0.66R*2%= 1.32%. This means that after this trade, our account is up 1.32%.
If we had information only about the end result in pips, we could not make a similar calculation. And we need it to calculate the correct Money Management.
Article by Professional Trading Systems – Forex Mechanical and Automated Systems