Risk Management · Lesson 7 · Advanced

The Trade as an Option

You think in R units and reward-to-risk and understand why payoff beats hit rate.

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Payoff before hit rate

With a hard stop, your loss is the premium, that is your 1R. The gain is open. A 90 percent hit rate with unlimited loss is a sucker's bet.

Murphy wants at least 3:1 reward-to-risk. The best traders win only around 40 percent of their trades and still make good money.

Play with win rate and R. See that 40 percent at 3R wins.

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Test yourself

Strategy A: 40 percent win at 3R. Strategy B: 70 percent win at 0.5R. Which one has a positive expectancy?

Only B, because the hit rate is high
A by a lot, B only barely
Both are equal

The key points at a glance

Every trade with a hard stop is an option: loss capped, gain open.
A 40 percent hit rate at 3R beats a 70 percent hit rate at 0.5R.
Cut losses, let winners run is the practical expression of it.

Deep dive

Why high-winrate strategies still lose money

A 90 percent hit rate sounds safe, but it is often the opposite. If you collect many small wins and let the rare loss run, you are selling a naked option: premium comes in regularly, tail risk is unlimited. That is how grid bots and martingale systems die.

Van Tharp explains the thinking error: we are risk-averse with gains and risk-seeking with losses. So we take profits too early and hold losses too long. Thinking in R with a hard stop mechanically reverses this reflex.

How to calculate your own expectancy

Expectancy per trade is the only number that counts: hit rate times gain in R, minus loss rate times 1R.

40 percent hits at 3R: 0.4 times 3 minus 0.6 times 1 = plus 0.6R.
70 percent hits at 0.5R: only plus 0.05R. The first is twelve times as good.
Profit factor: sum of gains divided by sum of losses, good systems run 1.3 to 2.
Journal every trade in R, otherwise you do not know your real expectancy.

Putting R-thinking into daily practice

R decouples the emotion: in R units every trade is worth the same. Larry Hite risks only 1 percent and is therefore indifferent to any outcome. Ed Seykota's answer was the same sentence three times: cutting losses.

Order within a trade: set the stop first, technically, behind a real barrier. Position size follows from the stop distance and your 1 percent budget, never the other way around. If the stop sits far away, you trade smaller.

1R = your unit of risk: the loss you planned per trade (distance from entry to stop-loss). +2R means you won twice as much as you risked.

R:R (reward-to-risk ratio) = potential profit target divided by planned risk. 1:2 means double the reward against the risk.

Sources: Taleb, Murphy, Schwager, Kahneman

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