Compounding effect of larger bet sizes

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• 0:01Speaker 00

  Hey everybody, it's Michael Martin. Thanks for being here. Last week on Martin Chronicle, we talked about asymmetry in payoffs and how that can take the pressure off of you when your accuracy dips, or when the market changes and it's not so amenable to your particular trading style. And we left it off by saying that as long as you had this part here, which was the 5 to 1 payoff, your accuracy could drop to 1 in 5 and you would still effectively make money when you think about this from like an expected value standpoint. I think the payoff was about 100 bucks, $20. Here's

• 0:40Speaker 00

  100, less the 80, and that would leave you 20. Now, obviously, we said, can't make a living doing this with these types of numbers. The most important part of it, though, is that because of the asymmetry, your accuracy can go in the toilet and you can still be profitable to a degree where you don't have a drawdown. Now, maybe the 20 part of it, like here, the 20 bucks, goes to cover commissions and fees. That's still fine, because all of that goes to drawdown anyway, and you don't want to be in that neighborhood. So, we started to think like, okay, well, let's go back when it's normal. I'll just redo

• 1:19Speaker 00

  this. So, let's say that I'm normally correct about 40% of the time, right? And now I'm going to be right. Let's do this with the green. Green is good. And from this, we'll be wrong 60% of the time. And then we're gonna put the red in there. We'll lose 100, just to make it nice and pretty. So, this effectively became 200, right? And this was 60. And then we had expected value of $140, right? It's fair enough. That's a review

• 2:03Speaker 00

  from last week. If you didn't see that video, you can go backwards and take a look at it. It's called Remove Pressure with Asymmetry. That was last Friday's episode. So, this just kind of helps you, like I said, when times get tough. We know that when this gets cut in half to 1 in 5, as opposed to 2 in 5, you can still be profitable. Obviously, the expected value drops precipitously too, from 140 to 20, which, again, you can't make a living on. But the goal is to try to not lose. Make sense? So, let's check this out. One of the things that the pros do, that a lot of you aren't doing yet, because you

• 2:48Speaker 00

  haven't gotten there, and it's okay, is that when they find their massive winner, their A-plus setup, whatever it might be, they actually scale up and risk more money on the trade. They bet bigger. They make an asymmetric bet on the actual setup itself. Now, you might not be there yet, but I guarantee you, like, whether it's the guys that I, you know, was mentored with and became friends with from, say, Commodities Corporation to anyone else who's been in any of the Market Wizards books that you like, what they do when they find, in those rare instances, when they come up with their amazing, you

• 3:30Speaker 00

  know, setup that they trade, they completely jack the thing up and trade it with a much larger amount of money. So, let's take a look at this and let's learn together. So, when we look at this, this is like what we would call your R, your risk unit, right? But that's just on a per-trade basis, right? So, let's take a look. What happens, though, if you're trading on a desk, or if you have several positions on, or you know that you could, you probably have what we call a portfolio heat, or like your daily max loss.

• 4:10Speaker 00

  This is just one loss per trade here, meaning per this one position. But imagine, since this is, again, we're going to label this as your A-plus setup, and with nothing else out there, and no real B or C, and obviously, D setups, however you want to rank them, they really don't get much attention. But you can basically risk your daily limit, or a bigger percentage of it, on, right, your A-plus setup when you come across it. So, say, for example, your daily limit was, say, 500 bucks. To lose across everything,

• 4:51Speaker 00

  you can take some of that and add it here to your 100. Make sense? And up your position size. This way, you're trading your best, and you're trading your biggest on your best setup that you know has a very favorable payout. You know it's 5 to 1. You know your accuracy is 40%. You know your daily limit is $500. You see what I'm saying? But now you've set your R at 1. Why? Well, because you want to be able to trade across the entire day. This is just one particular trade. So, what you can do is aggregate this. You can

• 5:32Speaker 00

  aggregate your R and say, well, my R's going to be a little bit bigger on a per-trade basis, but what I'm going to do is I am going to... Hang on, my monitor just went off for a second here. Oh, yeah, I gotta do this. I used my wrong finger, sorry. So, what you're gonna eventually do is use... Sorry about that, folks. You're gonna use some of the money that you would have used for other trades and allocate it here and increase your R. It's not going to increase your daily risk. It's going to increase your per-trade

• 6:12Speaker 00

  risk to a certain degree. So, let's just say that for this particular trade, you're gonna up this to, say, 400. Make sense? Now, your daily limit was 5, but now you're risking 4 on this one particular trade. So, that means you only have room for 100 more to risk. But with the 5 to 1 payout, and with the higher percentage of wins, you know, everything else scales as well. So, if you're gonna risk 4 times as much money on your bet size, because, again, this is your A-plus trade setup, you could make, you know, 2K.

• 6:56Speaker 00

  Make sense? When you win 40% of the time. So, it's not necessarily cheating, but it's taking advantage of your level of confidence, your ability to execute, your knowing on a very objective basis that you have a 40% win rate, and you know that this A-plus setup has paid you very, very handsomely. It doesn't make sense to have consistent or uniform bet sizes across the board at this point. This is how everyone does it, whether you're playing poker, or whether you're playing, you know, the markets. You have to know when to scale up in an objective way. You're not just pulling this trade out of the hat because

• 7:38Speaker 00

  it's your favorite ticker, or you have a fascination with how you're gonna play the bounce in the semis, or that sooner or later, MSTR is gonna go, or that this particular name that you've been watching that has 11 days to cover, you know, short interest ratio, has to rip. You know, that's kind of subjective. You're looking, you're coming up to this conclusion because you have the data. And the data drives your decision-making process. Now, it doesn't mean that you're gonna win. It also means, like, you're staying within the parameters of what your daily max loss would be across all your positions. So, you're not really taking on much more risk. You're just allocating more of that money to a trade

• 8:23Speaker 00

  that you know that comes up between once a month to once a quarter to have a much higher payout. You see what I'm saying? And so, obviously, the payout's gonna be 4 times the size, right? Because it's all proportional. If you do the math, this will come out to be whatever it is, 800, and this becomes 240, which equals expected value of 560, which is equal to whatever the first one was, 140, right? Which would be times 4, right? Because this is now 4 times that. But now, your average win is gonna become 4 times

• 9:01Speaker 00

  as large as well. And then, when you find these setups, your account is growing, right? And it's compounding. Because this is how you get parabolic moves in your equity curve, is you wait, you have to be patient, though. You can't just throw it on because you figure you want to size up. You see what I'm saying? You have to do it at the portfolio level as well. You can't just decide and say, well, I really feel strongly. Feeling isn't a strategy.

• 9:39Speaker 00

  It's an emotion. So, you need to have the math to back this up. But, and to be frank, I kind of did this instinctively without necessarily knowing the math behind it. I mean, I knew the math. I didn't apply it at the time because I was ignorant. You know, I didn't know. It just said, I just said, oh, you know, I see the setup, and when I do it, it pays me. I'm gonna keep my risk in check. And again, I'm not going beyond the boundary of what I'm willing to lose on any one particular day.

• 10:12Speaker 00

  You could do it by the week. However, most shorter-term traders look at their daily risk, right, which certainly has to be smaller than their weekly. But you might say, "Man, I know that this is my absolute Wayne Gretzky, Michael Jordan, Aaron Judge killer trade. And whereas I might have $5,000 for the day, that's $2,500 for the week. If I see this set up, I know in my heart of hearts, I might put $2,000 up as this number, right? I might clean this out and come back and say, "Whoops,

• 10:56Speaker 00

  this is now 2K." Because then this one is going to be 8K. No, 10K, sorry. Where's my... That's broker math. Trust me with your money, right? So this will be now 10K. But those are extremely rare circumstances, right? Too... Oftentimes, when I did this, I had the money to lose. I was on a big winning streak. My equity was burgeoning. So I was only, when I thought about this particular number here, I'll use gold, I knew I had that to lose because I had been doing well in other markets. In previous episodes, earlier this week, I talked about '05, '06, 20-something years ago, when gold, copper, and sugar all went parabolic.

• 11:41Speaker 00

  It afforded me the opportunity to be much more aggressive. I was kind of... I don't like saying "in the zone" because I'm kind of always in the zone. Even when I'm losing money, I'm in the zone, right? Losses are just... If you want to be a pro trader, losses are part of the business. Get used to it. But you... Over time, when you develop your instincts, you're going to kind of... I kind of feel it in my body first. My body's... You know, Ed would call it a protective warning. And I learned to kind of figure that this was my body talking to me from having sensed something in the environment that was advantageous for me to be in. It doesn't always have to be a negative thing. It could be an opportunity.

• 12:23Speaker 00

  So this is a rule that you can use. But you obviously have to stay within the daily confines and/or the weekly one. So I said, like, if we have... Let me use blue. If 500 was your daily max loss, you could risk 250 of that as opposed to doing five trades at 100, right? Because it all works out. You could do 10 trades of 50, two, right? You could do one at 500. But you have to stay within those parameters. If you're even more experienced and you wouldn't mind taking the rest of the week off if you lost, you could say, "Well, that's, you know, 2,500 on the week," right? And if you lose it, then you're done until next week. You can't cheat.

• 13:08Speaker 00

  Well, you can, but what ends up happening is you could be putting on a trade out of emotion. You see what I'm saying? So you have to stay, like in golf, we talked about in a previous lesson. The pros, they try to swing really hard, generate a lot of clubhead speed with an inside-out swing, but they stay within themselves. You need to know what your numbers are. This isn't just random numbers that I'm picking out of a hat. It's numbers that you would have gotten from looking at your trading history and then breaking down all of your trades and seeing, "Okay, here's how my day-to-day trades work, and here's how the ones act when they're grand slams. I can afford to bet bigger on these."

• 13:51Speaker 00

  You still have to stay within the parameters of tight risk management, but that's how you really get paid. Because when you see that A-plus setup and you don't oversize it, you're leaving money on the table, right? You're leaving money on the table. And that doesn't serve you, right? You have... There's a time when you deserve the right... You've earned the right to bet big on yourself because you have the numbers behind you, right? So... This is a sloppy zero. Should be 240. So at the end of the day, this is the kind of thought process

• 14:34Speaker 00

  that you can start to, like we talked about yesterday, quiet your mind and envision yourself putting yourself in this situation where you're like, "Yes, I'm doing well. My account is growing. I understand what the rules are now." Because anyone can tell you that three-of-a-kind beat two pair, but you have to know how to trade that when you're in that type of a setup, right? If you bet $100 every time, you know, every time there was a bet, your bet size, as the pot is growing, is actually getting smaller. So people... You know, that sends out information to the table. When you're in this type of a situation, I think you're in communication with the market and also with the universe,

• 15:18Speaker 00

  with your sense of self-esteem, that you're also worth it. You know, why wouldn't you try to maximize every opportunity, right? And people say, "Yeah, I always think outside the box." Okay, well, this is an example of doing that, right? You have to, you know, talk the talk now. So now, in this latest instance, don't forget, we said you're betting 2K, which is about, whatever that is, 80% of what your weekly limit is here. And if you lost that, you know, you'd still have 500 for the rest of the week. But you don't want to go beyond that and put yourself in a bad spot because you're going on tilt or you bet big on something that you thought was a sure thing,

• 16:03Speaker 00

  blah, blah, blah. So follow your rules. Maybe you buy an initial piece. Maybe you figure out how to add to a winner, right? There's a lot of moving parts that go in here. This is just the math at the end of the trade. But at the heart of it is the 5-to-1 payoff, right? And the known percentage of winning, which is 40. Now, a few people have commented about 5-to-1 and this and that, and "shoot for the stars," and blah, blah, blah. You know, you can actually start to do some backtesting and look at the data because 5-to-1 is not that far off. I mean, for example, if you're a scalper

• 16:47Speaker 00

  and you find yourself risking 10 cents, 5-to-1 obviously is 50 cents. If you're risking a quarter, you're looking for $1.25. Like, so you could find it. You have to look to the left on the chart, though, right? If there's overhang or there's upwards resistance, it might be hard, so you have to pass on those trades. These types of payoffs work really great at 5-to-10-year highs and certainly historic highs because there are no trapped buyers. And when you think... Let me erase this for a minute and give you an example because I'm a visual learner and I learn from pictures as much as anything. So let me show you what I want to demonstrate. This will really help your way of thinking, I think. Ding, ding, ding. Let me go back here.

• 17:32Speaker 00

  So when you look at a chart and you've got a bunch of green days, green bars, green bars, green bars, green bars, and then inside of that, you've got a couple of red bars. The thing goes down, this and that, but the trend is generally up, you know? And you find yourself... Let me use the blue line here. And this is what we would call an all-time high. You have to think what's going on at that moment of time, right? Because down here, this would be time, and this would be price. At the dotted line, what's above the dotted line at an all-time high, right? Let's think about this for a minute.

• 18:15Speaker 00

  Well, there are people in the world who are just negative, right? And they fade everything. They're just built that way. They don't believe people... It's a personality trade as much as it is a trading style. So when they fade and they were shorting at some of these levels here, what they typically do is they put their protective stops in above prior highs, and they position size accordingly to take into account what that distance is. So at the... Right above the all-time high, what you have are short covering, right? I'm just going to write COV, right? They're fading, they're short covering, so there's buying pressure actually above the market.

• 18:59Speaker 00

  Now, this happens the more the market goes higher. Why? Well, hedge funds oftentimes trade in pairs. If you look at certain entities, especially like a Citadel, they're not buying anything long necessarily outright. They're buying the best name in the industry or the sector long, and they're selling another one, the glue factory horse, short. And then they're levering that relative value trade up, right? So that's... So when do they know they're wrong? Well, listen, all they need is the long trade and that pairs trade, right? With their long one name, short the other. They just need the long to outperform the short. So in this case, if the name was...

• 19:43Speaker 00

  This was a particular short sale, it can very well go up and go against them, and they stay in the position as long as the long name, the ones that they bought and held, are outperforming, you see? Because they're trading it as a relative value trade. Now, there is a point where they could capitulate. When that is varies by position, varies by pod, right? Because the idea for them is that they're not necessarily looking to take directional bias as much as they're looking for relative value in a bit of a market-neutral way, and then they're using leverage, right? So that all goes together, right? All of those pieces matter. Now, let's look at who else is at an all-time high.

• 20:26Speaker 00

  Well, there are people who buy breakouts. And normally, they define themselves as buying, whether it's a five-day... "I buy 10 days." "I buy 20 days." "I buy 55 days," right? So this number here is what we would call N. It's a variable for that number, N. And when you get to the all-time high level, right, and you put in that buy-stop, the all-time high triggers every N-day system.

• 21:05Speaker 00

  So if I have a one-day breakout, a two-day breakout, a three-and-a-half-day, a four-and-seven-eighths-day breakout system, I'm being facetious. The all-time high triggers all of that. So now, at the all-time high, you really have a lot of buying pressure. You have the shorts, the shorter-term shorts, who are looking to cover. As the price moves on, you will have the longer-term players, who are using this particular instrument as the anchor to a pairs trade that eventually have to get out. Because they've borrowed stock that doesn't belong to them, they have to buy it back. And then you have every end-day breakout system trader who's also looking to get in.

• 21:49Speaker 00

  So really, anywhere above the market here, right? I'll use the gold. There's enormous amount of buying pressure right there. And there's no overhang. So when you look to the left, there's nothing on the chart. There's no anchored VWAP, there's no prior high where there could be trapped buyers. It's nothing but clear blue sky. So when you think of this, and you put this all together with your bet sizing, it does look... Does it always work out? No, nothing's 100%. But you have to understand what's the psychology of everybody else in the marketplace, and then play judo.

• 22:30Speaker 00

  You're using those forces in your favor, and that, to me, warrants, when you find those exceptional, in extraordinary circumstances, it absolutely warrants your betting bigger. You see what I'm saying? Now, you can do this with shares, futures, or options, it doesn't matter. We don't play favorites here. So, think about all of this, and, like we talked yesterday, quiet your mind and envision all of this happening. And then envision yourself actually executing this with absolute peace, with absolute calm. You know where you're getting in, you know where you're getting out, you're staying well

• 23:14Speaker 00

  within your daily and your weekly position limits in terms of the capital that you're willing to risk, and you're just amplifying that on your A-plus setups. If you do this enough times, this is really how you grow your account in a parabolic manner. It's been a great week, thanks for being here. Get your copy of The Inner Voice of Trading at TraderMindset.com, it's free. Have a great weekend, folks, and I'll see you Monday.