How to determine your optimal trading bet size

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• 0:00Speaker 00

  Hey everybody, it's Michael Martin. Thanks for being here. Today, let's talk about bet sizing. You know, there's a lot written about it, and I think if you're unsuspecting, you might get confused as to what or why or how you should be doing it yourself. You know, some of the better traders out there, they might have different bet sizes for the different setups that they might be trading. Well, if you're just starting, you know, you're not there yet. You don't have five setups that you could trade profitably with varying, you know, asymmetrical payouts. You're trying to figure out one style. What I did when I started out was I used a percentage of my account, and I kept that consistent across every trade. Now, that might not have been the wisest thing to do in terms of making money,

• 0:42Speaker 00

  but because my account was so small, the water was cold. The thing is, it kept me grounded. Because then I was able to look at every trade as being just the same percentage. I didn't get emotionally invested in the outcome of the trade. Right, which can happen if you have a sure thing, or if something you feel very, very strongly emotionally, right? Or fundamentally, you might have certain proprietary knowledge that's, you know, part of your domain, right? If you come from technology and you know how to code, you might think that there are certain trades out there that are just dynamite. Because you have an affinity for that information. That could lead you to put on bigger bet sizes than you might, you know, need or want to do.

• 1:27Speaker 00

  And so what happens is when those go south against you, you're gonna have a much stronger feeling when you toss the coin and it comes up tails. I didn't want that. I knew I was smart. I had all the schooling in the world to show me that. But I knew that that was gonna get in the way, right? I was smart enough to understand. Once it clicked, I didn't know it right away, but like six to nine months in the game, I realized like, what I thought was an informational advantage was, didn't exist at all. At all. So I was like, okay, I gotta, I have to, this is my chance to have a nice white-collar job here. I have to figure out a way to get my head together, right?

• 2:12Speaker 00

  So that's what I did. I got my head together and I said, let me, let me put on a uniform risk unit that would be the same or consistent across every trade. This way, if sugar goes against me, or if Wendy's quick-service restaurant goes against me, I'm not gonna look at that any other way than a fixed, you know, 1% risk unit. And I still did that well into my professional career, right? And so the benefit of doing it that way early on in your career is that you can stay emotionally and psychologically placated across every trade, no matter what you're trading.

• 2:54Speaker 00

  Now, if you're a short-term trader, you might have a daily limit. For me, I had a limit on every trade that I put on. Now, sometimes that would probably exceed, like, it's not uncommon for a short-term trader, scalper, maybe day trader to say, "My daily risk unit is, I'm gonna lose 10K." Right? Maybe it's a thousand. Doesn't matter what the number is, right? And then what they'll do is they'll say, "Okay, for my A setup, that's gonna take the lion's share of that trade." That might take 50 to maybe 80% of what my daily limit is. I didn't work that way because I only had one system and one set of rules that I was following. So every trade, right, was the same type of breakout pattern,

• 3:36Speaker 00

  and each one had a 1% risk. So be careful about that. So you need to put in other rules to manage your P&L and trade, because ultimately, we trade our equity curve, right? So when you put that on, you start to think like, okay, well, I have three positions on. There wasn't too many times where I would have five or six positions on at the same time. Why? Well, because most markets aren't trending. And if you think about, you know, the way I divided up my cash, I could get much more leverage in commodity futures. So that's what I kinda stuck with. Two, I grew up in New York where I understood crop years because I grew up in it. You know what I mean? The seasonality was a real thing.

• 4:17Speaker 00

  It wasn't just four quarters on a calendar for financial reporting. You know, I lived it. You know, winters were cold, summers were hazy, hot, and humid, and that's the way it was. And I loved it. So at the end of the day, you might consider saying, "Okay, well, I need to break this up and do this a little differently." My, I was probably a little bit more aggressive in that if I was trading 1% risk units, you need to put on another fastener, if you will, to help you manage the risk. What do I mean by that? Well, if I was risking 1% across three or four trades, it's entirely possible that they could all go against me in the same day. Now, I was very careful not to have too much correlation risk,

• 4:58Speaker 00

  which means I wouldn't typically have gold and silver in the account at the same time. I might have, right, so where do you see that today? Semiconductors, right? You don't, if you're gonna buy a basket, make sure you cut the risk on all of them so that the basket represents a certain type of risk that you know you could withstand. Copper, to me, was more of an industrial metal, so it was a little different than, you know, gold and silver, although they have commercial uses. Nickel, tin, zinc, that kinda stuff too. You'd have to trade that in London as they were forward contracts. So I would break up those positions and say, "Okay, well, they're not correlated, fine, so I could have the full risk unit on." But then I did something that was pretty clever that I borrowed from Paul Tudor Jones,

• 5:43Speaker 00

  and that was, I would make sure that I didn't wanna have like a double-digit down month. So if I was coming into the end of the month, or if I was down, say, 5%, I would start to trim my overall account size and take a haircut, kinda trading it like a synthetic value. So say I had, in those days, you know, I had tens of millions in assets of my own money and client funds. So what I would do is, if I started to see that I was going into a drawdown, and my risk unit might be like 25 crude oil contracts, if I was into a drawdown, I didn't wanna, meaning I didn't wanna have a 10% down month. So what I would do is, I would start to trade it as if I had 15 million.

• 6:28Speaker 00

  And so I would position size on the 15, not the full 25. Because I didn't want, you know, drawdowns can compound as well. And so you have to nip them in the bud, fast, right? They can get out of hand quickly. And because you don't know ahead of time, you know, if you study robustness, right, in trading rules, you could look over, you should be studying 10 years of data at least. Never mind, you know, maybe 20, depending on the type of model you're running. And you'll find that there'll be times where there'll be these wild losing streaks, and they have nothing to do with you. The rules are exactly the same, right? And when you backtest, it doesn't predict anything, but it gives you a sense of like what I call forced objectivity.

• 7:13Speaker 00

  In that you would take the trade no matter what you were thinking back then, and if it was 15 years ago, who knows what the hell you were doing or what you knew about money. So you put, you put the trades on and just kinda see what those results were. And so when you're in real time, you don't know when, what, you know, because a 10% drawdown has to be a 2% drawdown at one point, right? It grows up. And if you're in something that was, you know, 20%, it has to have been eight or 10 at one point drawdown. So I was like, I wonder if there's like a leading indicator, you know, other than something like, something as simple as what I just said? Like, what's the, what's the, what's the, if you think of Bayes' theorem and conditional probability,

• 7:56Speaker 00

  what's the probability of a 20% drawdown, given the 20% opportunity to be down eight? You'd have to look back and see what those numbers were. So I would very quickly, you know, they say fisher cut bait. I would very quickly go to, go to cash and just say, "I don't have anything other than my intuition at this point to kinda stop trading or slow down. Because what I'm doing doesn't seem to be working in the marketplace right now." Now, as you get better, right, you, you can absolutely divide up your cash the way I mentioned before. You know, your daily risk is, say, 10K, and then you'll get to figure out how do you wanna chop that up on any given day.

• 8:38Speaker 00

  For me, I was taking things home overnight. So some of those positions, they might be down against me. Some of them could be up against me. You can see some of that in, in the little webinar that I have here. So, you know, how do you deal with that, right? You have to pull your weeds and let your flowers bloom. And sometimes when you're in a drawdown, like in the webinar, you know, it's tricky because I was down 12%, right? That was, that was my own money, that, that particular account, and I was already a pro for 16 years. So I'm talking about a window of time that's a little bit earlier because I knew your track record follows you.

• 9:18Speaker 00

  You know, your track record and your compliance history are really your franchise value in many ways. So you have to have a clean compliance track record. You have to have, you know, clean...

• 9:31Speaker 00

  You know, you want to be mindful that in your performance capsules, as what they were called in those days, might be the same thing. What I didn't want to do is I knew some of the really, really good traders out there had 20 to 30% drawdowns and they were purely systematic. And I was like, my God, these guys have hundreds of millions to, you know, now they probably have billions under management. I'm not going to be able to compete with them because they have a big brand name. They're already in business with big broker dealer FCMs. They have hedge funds and pools. And so I can't show up with the same type of track record because people are going to look at me like, look, we already have this or what you're presenting with somebody who we already have money. So how are we going to improve?

• 10:15Speaker 00

  I wanted to be a different horse in the stable. I needed to look different, right? So that means I had to do things differently. And one of those things that I was pretty clever about, I don't talk about it a lot because everyone wants to know what's the next best trade? What's the model? You know, should I scalp? Not losing money is a huge asset to your trading strategy. And I knew if I could go in and approach people as an emerging talent and I had small to low drawdowns, that money was going to flow to me. Now, there were other guys who were pros that told me that same type of deal. Like if you could make double-digit returns and have single-digit drawdowns, the money's going to show up on your doorstep.

• 11:00Speaker 00

  And that's kind of what happened in many ways. So be mindful if you're trying to go out and be pro of what the draw, you know, carve that out of stone, know and manage your drawdown as much as you're trying to manage for the upside. Everyone wants to make money, there's no doubt about it. You have to be able to, you know, create alpha. But I can't, I can't, I can't stress enough how important it is to sidestep what could be otherwise very, very large drawdowns. Right? And that does wonders for asset gathering. It also does wonders for your psychology. Because guess what? You could come back in a month's time and the market's going to be there. The instrument that you want to trade is going to be there. And life is going to go on. And I knew that.

• 11:44Speaker 00

  I knew like these markets are going to survive me. I'll be long dead, they'll still be trading. So if I take a week off or two weeks off, I'd rather do that. Right? Because it's not macho to trade through it, right? It's not about that. You have to preserve your mental capacity as well. Like the last thing I wanted to do, because I could, one of my skills was, and this is an edge, I don't know how I could describe it mathematically, is that I can project myself two months into the future and feel feelings in the future and say, okay, if I did this thing today and I tried to bull my way through something, let's take a look and storyboard what some of those outcomes could be. Well, one could be abject humility, like I knew better, but I did it anyway.

• 12:28Speaker 00

  Is there any part of your life where you did that? And then what was the result? And then how did you feel? So I projected myself into the future and said, okay, I'm in a 6% drawdown. If I keep doing what I'm doing, I could be down 10, 15%. How am I going to feel if I saw the signs and didn't take some kind of flashing yellow? It's not green anymore, it's at least flashing yellow, right? As a traffic sign, if not a flashing red, which means come to a full stop, then go. So I would project myself into the future and then I would feel the feelings of the activity or lack of activity that I was taking today. And I would say, okay, how does that feel? Because the money you could always get back. But how does it feel?

• 13:13Speaker 00

  What does it do for your confidence? Did I let myself down? And then I would recalibrate my current real-time system to avoid that situation in the future. And that meant taking haircuts on my capital, trading it with, as if it was 6. Sometimes I, you know, I might have even cut it, say, to 10. You know, I might cut it down 60% from, say, 25 to, say, 10 million. And then, you know, go from there. So this could, this could work miracles for you when you're thinking about managing risk for yourself and you're running into a wall of, not bad trading, but just trades that don't make you money, right?

• 13:57Speaker 00

  You have to learn to separate that losing trades. If they're still, like what we would say in model, they're not bad trades, they're just the ones that are going to go into the losing bucket, right? If you did 100 trades and you win 40% of the time, 60% of the time, you're going to follow your rules, but they're just not going to work out. So it doesn't mean they're bad trades, they're just part of the losing trades. So I had to learn to not internalize that as well. Anyway, thanks very much for being here. There's no episode tomorrow. Have a great weekend and I'll see you Monday.