Hey everybody, it’s Michael Martin. Thanks for being here. Last week on Martin Chronicle, we talked about asymmetry and 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 five to one payoff, your accuracy could drop to one in five and you would still effectively make money. When you think about this from like an expected value standpoint, I think the payoff was about a hundred bucks, $20. Here’s a hundred less than 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 draw down 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 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.
Um, and from this we’ll be wrong 60% of the time, and then we’re going to, um, put the red in there. We’ll lose a hundred 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 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, asymmetry. That was last Friday’s episode. So this just kind of helps you.
Um, like I said, when, when times get tough, we know that when this gets cut in half to, to one in five, as opposed to two and five, you can still be profitable. Obviously the expected value drops precipitously to from 140 to 20, which again, you can’t make a living on, but the goal is to try to not lose. Makes 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 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, 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 some, 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 know, setup that they trade, they completely jacked 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, are 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. This is just one loss per trade here, meaning per, per this one position. But imagine since this is, again, we’re going to label this as, 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, your daily limit was say 500 bucks to lose across everything, you can take some of that and add it here to your 100. Makes 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 five to one, 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 one.
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, is aggregate this.
You can aggregate your R and say, well, my R is going to be a little bit bigger on a per trade basis. But what I’m going to do is I am going to, um, hang on. My monitor just went off for a second here.
Um, oh yeah, I got to do this. I’ll use my wrong finger. Sorry.
So what you’re going to eventually do is use, sorry about that folks. You’re going to 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 risk to a certain degree.
So let’s just say that for this particular trade, you’re going to, you’re going to up this to say 400. Make sense? Now your daily limit was five, but now you’re risking four on this one particular trade. So that means you only have room for 100 more to risk, but with the five to one payout and with the higher percentage of wins, you know, everything else scales as well.
So if you’re going to risk four times as much money on your bet size, because again, this is your A plus trade setup, you could make, you know, 2k 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. You’re 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 it’s your favorite ticker, or you have a fascination with how you’re going to play the bounce in the semis or that sooner or later MSTR is going to 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’ve have the data and the data drives your decision-making process. Now it doesn’t mean that you’re going to 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 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 is going to be four times the size, right? Cause 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 four, right? Cause we’re, because this is now four times that, but now your average win is going to become four times as large as well. And then when you find these setups, your account is growing, right? And you’re, you’re, it’s compounding because this is how you get, um, 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.
The feeling isn’t a strategy. 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 going to 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.
You could do it by the week. However, most, 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 5k or excuse me, $500 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 2000 bucks up as, as this number, right? I might clean this out and come back and say, whoops, this is now 2k. Cause 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? To 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. It afforded me the opportunity to be much more aggressive. I was kind of, I don’t like saying in the zone cause I’m kind of always in the zone, even if I’m, 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, you know, Ed would call it a protective warning and I’d 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. So this is, 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, I said, like, if we have, let me use blue. If 500 was your daily max loss, you could risk two 50 of that as opposed to doing five trades at a hundred, right? Cause it all works out. You could do 10 trades of 52, 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 if you’re all you can. But what ends up happening is you, you could get, you could be putting on a trade out of an, 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 suite speed within a 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, 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. You still have to stay within the parameters of, of tight risk management, but that’s how you really get paid because you, it, when you see that ace a plus set up 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 two 40. So at the end of the day, um, this is the kind of thought process 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. You, you, if you bet a hundred dollars 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, when you’re in this type of a situation, I think you’re in communication with the market and also with the universe, 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, if that, 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, blah, blah, blah.
So follow your rules. Maybe you buy an initial piece. Maybe you, 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, at the end of the trade. But at the heart of it is the five to one payoff, right? And the known percentage of winning, which is 40. Now, a few people have commented about five to one 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 five to one is not that far off. I mean, for example, if you’re a scalper and you find yourself risking 10 cents, five to one, obviously is 50 cents. If you’re risking a quarter, you’re looking for a dollar 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 five to 10 year highs and certainly historic eyes because there are no trapped buyers. And when you think, let me erase this for a minute and give you an example.
Cause I’m, I’m a visual learner and I learned 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. So when you look at a chart and you got a bunch of green days, green bars, green bars, green bars, green bars, and then inside of that, you 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 isn’t what we would call an all time high. You have to think what’s going on at that moment of time, right? Cause down here, this would be time and this would be price at the dotted line.
What’s what’s a, what’s above the dotted line at an all time high, right? Let’s think about this for a minute. 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 old, 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. 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 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, 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 so 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.
Well, there are people who buy breakouts and normally they define themselves as buying, whether it’s a, 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, that buy stop, the all time high triggers every N day system. 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 who, who are the shorter term shorts who are looking to cover as the price price moves on, you will have the longer term players who are using this, 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 N day breakout system trader who’s also looking to get in. 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 are no, 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 a hundred percent, but you have to understand what’s the psychology of everybody else in the marketplace and then play judo. You’re using those forces in your favor.
And that to me warrants when you find those exceptional, uh, 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 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 trader mindset.com. It’s free. Have a great weekend folks.
And I’ll see you Monday.
