Hey everybody, it’s Michael Martin. I hope you’re doing very well. So I get some really good questions from everybody who watches and I really appreciate it. It’s, it’s very, very good. Gives me some feedback, maybe it helps me understand where I wasn’t clear on certain things, but it also helps me get to the heart of the matter where I can really answer a question such a way that it makes a big difference for you in the way you interpret what I’m saying and how you can take it and put it to work for you right away. So comment on one of the videos was how can you please help me get to be more accurate as a traitor? And at first I was just going to write something back then I said, nah, let me think on it. Then. It occurred to me that trading isn’t necessarily about accuracy, it’s about expected value. The problem is the way we learn and the way we’ve been conditioned to learn. So when you think about the expected value of a trade, it definitely helps you see and visualize where what it is that your edge is or where your edge is. So the formula for calculating expected value, it’s probably pretty simple. It’s all over the internet. You might have seen it in a course that you’ve taken. It doesn’t take a lot.
It starts with the winning percentage. And with that, you’re going to multiply it by the average win and then you’re going to subtract your losing percent. And then what it is you lose when you lose and that equals the expected value. So when you do enough trades, you can keep the data and calculate what it is where your edge is at. So I’ll use a hundred as an example. It’s not a big number, but it’s enough to kind of see. So say after a hundred trades, you find out that you have 40 wins and you have 60 losses. From an academic standpoint, that’s an abject failure. If you’re batting average, if you’re in B American baseball, you’re going to the Hall of Fame because you have Ted Williams style numbers. But if you’re looking this as a pass fail, you can think, if you think of it academically that you’re somehow a failure.
I don’t believe that’s the case, but you might be able to see that yourself. Depends how you process information. So the question then becomes how can you make money if you only win 40% of the time? And I chose 40% cause I didn’t want to say that you have coin toss odds, meaning 50 50. I wanted to show you that you can lose more than half the time. You win less than half the time, but still make a lot of money. And it comes down to then this ratio here. What is your average win to the size of your average loss? What’s that ratio? So if you used something like three to one, which means my winners are three times the size of my losers, it means also that one winner pays for three losers. That’s another way to look at it. And now that we have these numbers, we can kind of plug them in and just come up with an example and go from there.
So my winning percent is 0.4, and when I win, I win three times. Whatever my risk unit is, right? That’s this number. So then what’s my losing percentage? Well, it has to be the compliment of what I win. Cause I can only have a hundred percent of everything. So when you think of these two numbers, they have to equal to one. The way I’ve written it, right? Point six is 60%, right? Point four is 40%. So you could look at it however you want, but it has to compliment each other in that it adds up to a hundred, right? Then you have the relationship between your winner and your loser. Whoops, I still have the damn eraser on. And that would be this ratio here, three to win, three to one. You see that? And so when you start to think about the accuracy game, you might be missing out on all the other moving parts because now I have one, I did it again, I have 1.2 minus 0.6, and so therefore my expected value is 0.6. And so you can use, when you think of this three here and this one, you can use R, you can use dollar signs, you can use percentages. It all, it depends on what the best orientation is for you. So the question came in and said, Hey, can you help me be more accurate with my trading? And normally I kind of can. I’m sure that there are things that I can convey to you.
So this comes in on the sneaky way you can undermine your trading profits. So that was the video and the comment came in from Stanford oh eight, Stanford with an M, not Stanford like the cardinal. Thanks sir. I hope you give us some insights on how to improve trading accuracy. So I want to change the nature of that question and think about, I can hope you can give us some insights on how to have a higher expected value or how we could make more money, because trading accuracy doesn’t necessarily mean making more money. In fact, the systems that I see that are really accurate, like 80, 90% accurate, they’re only accurate for small gains. I don’t see 10 to one or these crazy asymmetric payoffs with a 90%. You see, you’ll only know from trial and error because it’s not theoretical and it’s not absolute.
In other words, I can’t give you an absolute rule for this that would affect your trading. You have to go through trial and error. That’s why when we look at this, it’s a real number. It’s after the fact. So just like in paid traffic or advertising campaigns, your first month, two, three months, whatever it might be, isn’t necessarily to get results from your paid traffic to harvest the data to see what’s working and to eliminate what doesn’t work. So then you can go, I don’t do paid traffic, but I’m just using it as an analogy. That’s how you get to refine things. And so early on in your trading, you need to be able to go take the chances that you don’t want to take because you might not want to feel the feelings that are necessary with losing money because it was hard enough to get place.
So let me clean this page up a little bit. And anytime you have expected value that’s greater than zero, then that’s a system that’s worth following. That’s the rule of thumb. The higher the number, the better. So when you start thinking about accuracy, what you’re really thinking about is this is your winning percentage. How can I increase my winning percentage? Because everything else being equal, if that goes up, then my expected value value’s going to go higher. But I think to get accuracy improved upon, it’s actually harder because you’re powerless over what the market does. The best thing that you can do is put on your trades according to the rules that you follow. And I’ll use rules if you’re a discretionary chart reader and you have trading rules that you follow, whether it’s pattern recognition or pullbacks or stuff that other people teach, or if you’re purely systematic, I kind of refer to that inter system because I know people that are discretionary chart readers that can get quite robotic about it, meaning they don’t let their emotions interfere with their judgment and they can execute time after time.
So when someone can do that, it’s very close to being a pure mechanized system. And they don’t need the computer because they have extreme levels of discipline and they don’t let their emotions sidetrack them and knock them off balance. So if you’re an intellectual person, you’re absolutely want to increase your winning percentage because it feels good to be right. In America, you go to school from the age of six to 18 that you have to for the most part. So that’s 12, 13 years, whatever inclusive, where you have been graded on accuracy. Every true false quiz, every test, every paper, every fill in the blank, every term paper, every midterm, every final was graded on accuracy. And the more accurate you were, the higher the grade. And that happens systematically and in a very hierarchical way over years 12, like I said, 12 years, maybe 13 for some of you.
So that’s ingrained in your brain. So you’re always, your default is to let me read another book. Let me take another course, let me get another tool. Let me add another indicator, which is kind of what got me thinking about this in the first place was that you don’t need another indicator if you’re willing to feel all the feelings that will come up from your trading. You can’t insulate yourself from losing money. What you can do is make sure that when you do incur losses that they’re small, they’re paper cuts. Because what you don’t lose, you don’t have to earn back. Two. When you think about, whoops, I made a typo here. Pardon? Pardon, pardon me folks. Sorry about that. This is the average loss, I apologize. Sorry about that. So your average loss on some level, if you’re very systematized, even though the dollar science might vary small amounts, if you’re risking say one half of 1%, then every trade should be the same. So in that case, your average loss should also equal your largest loss because you always have it set with a protective stop no matter what.
Now, even if you’re using a simulator and you haven’t done trades, you might have found that these types of results had come up for you in your simulation. And the key one is this ahead of time that 60 out of a hundred trades are going to lose money if you followed the rules and the back test is positive because you have to take both. You have to take the thick with the thin. It would be great if you could just throw in, cast your fishing rod a hundred times and pull something in a hundred times. It doesn’t work that way though, as I’m sure you imagine. So one of the benefits of back testing is it gives you a reality check and shows you that you are going to lose money if you have a good simulator. It could also tell you how big the drawdown is and what’s its duration, what’s the magnitude, and how long is it’s going to last. I’m down 14%, it’s going to last five months. I don’t know what it is, but that could be helpful for you. Why? Because when it happens to you in real life, then you don’t have to freak out. Why? Well, because you can see it ahead of time. You can see that that’s a reality.
So then you go back to the drawing board and you say, well, okay, well I don’t like that. I’m going to have to cut this number smaller, keep my losses even smaller, because if everything else is equal, my winning percent, my average win, and even the frequency with which I lose that can all stay the same. If I decrease my average loser, then my expected value goes higher. You see? And that becomes another way that you could make more money. So I wouldn’t think there’s a few moving parts here that discuss making money in trading only one of which is accuracy, which coincidentally is in the equation for calculating expected value. So again, accuracy is important, but as you can see here, it’s not the only thing because if my winners are 10 times the size of my losers, I might be able to have a system that I’m only correct maybe 20, 25% out of the time. Now, how would that feel if you were putting on five trades where you knew four out of five of them were going to lose you money?
That’s a whole other type of emotional constitution that you have to process. So the easiest thing for me, let me clean this up a little bit, get some of the crap off the screen here just because when I’m talking, it could be a bit of a distraction. So I’ll take this off and I’ll take that piece off. So now that we’re looking at this, if you can’t necessarily change your winning percentage and your losing percentage is a compliment, right? Because your winning percent losing percent has to equal a hundred. One of the other ways that you could make a lot of money or make more money is to obviously cut your average loss as we just discussed, but also look at your average win.
Because if you increase your average win, everything else being equal, you can change these percentages or you can change the relationship between those two. You see what I’m saying? So that’s why I want to get you off of, don’t worry about the accuracy. That would be the last thing I’d worry about. What I’d be interested in is like saying here, okay, well my, let’s just say that my winning percent is going to stay at four and my average win was at three. I’m going to lose 60% of the time, and that’s going to cost me one risk unit and net net, there’s my expected value. Well, you can see then if I increase this number on my average win, then the product of this side is going to be even greater than this one, which would stay the same. So say my average win goes up a third to four, now I’m at what?
1.6 minus 0.6, you see? So you can see the mathematical effect of increasing your average win. Now, how do you do that? Well, if you have a winning trade, one trick could be to stay in the winning trade. Let me clean this up a little bit too and go back to what I had. I think this was three, right? So say that you are doing this in units of R, you make three R and you risking one R. Well, suppose you’re in a winning trade and the way you break it up, and so this is mindset stuff, but it’s also tactical. So see how it fits for you. Maybe you scale out of your winners. That’s not my style necessarily, but I know a lot of folks do it. So how about this? When you get to, if you’re not stopped out of your trade at your one R loss here, maybe when you’re here you say, well, when I get to three R, I am going to remove one third of the trade, and then I’m going to trail.
I’ll have my protective stop at now two R. So this way if it reverses on the other pieces, I’ll still walk away having made money, but I’m going to keep two thirds of the position on why I’m making money. I can perceive that necessarily as a good risk. So let’s go down and say, okay, well now at four R, after I let the thing run, let’s just say my protective cell stop is going to be two R. So I’ll raise it here for three R, and at here I’ll lift a third, and at five R, if I get there, I’ll sell the remaining third with a four R trailing stop. So now if you can do the average, you can see how your R level on your gains will go higher by how you’re scaling out of your winners. The good news is you can already say that they’re winning because you can see that on your p and l.
All you have to do is stay in those winning trades longer. Now again, if you’re day trading, it’s probably harder the longer you go out. If you’re like position trader more like me, or if you’re a swing trader, you know, can see about putting these rules in and scale out of your winners. So that should make this number higher. Now, you can test again with the fractions too. I mean, maybe you sell a half and you keep a half. I don’t know, you could sell forth. It doesn’t matter to me. It’s something that you have to test because there is no absolute answer. There’s only what’s best for you.
But then you can mess with the numbers, like I said, and say, this was your profit. I’ll put pie because economists use pie for profit, and then this would be your protective sales stop. Notice, I don’t say stop loss. Why? Well, because you’re making money and I just choose to use very specific language in my brain where I don’t want to emphasis losing. Yes, am I not making as much? I’m not. But the expected value of staying in a winning trade could actually be higher, especially since I haven’t tested it. That’s what you’re saying to yourself. So sell a third at three R, maybe trail it with a. So two R is where your stop is. So if the remaining position goes against you, you get taken out, you still make money on everything. If it goes to four R sell, I guess half of what’s left, it’s still a third of your initial position, but it’s half of what’s left.
So you’ll sell that at four R and then raise your protective stop to three R. So if that last third reverses, you’ll have two pieces sold at three R and one sold at four R. You’re still going to skew the average of your average win higher, which to me is easier to do than worry about getting more accurate because every system that has positive expected value is going to have times when it goes crazy and times when it looks like it’s just the worst trading system in the world, especially when you’re in a drawdown. You see what I’m saying? So as Warner Wolf would say, let’s go to the videotape and investigate this even further and put some numbers to it. Again, you can figure this out in your own notebook on how you want to do it, but let’s just say that you started with 40% winning per percentage, and you made three times the risk unit and you lost your risk unit 60% of the time. That equals your expected value. So if we did the math here, it’s 1.2 minus 0.6. So the expected value is 0.6. So let’s just say that you can increase your winning percentage, excuse me, your average winner by 33%. So let’s change that to four, right? Everything else being equal.
So now it’s one, right? It’s 1.0. Here’s 0.6. Now I have 1.6 minus 0.6. So now it’s one. So check it out. Look at the factor on the multiplier here. From three to four, we improve 33%. Fair enough. What is it when you go from six to 10? It’s 0.6 to two thirds. So I increase my profitability at a higher magnitude than I actually had my own profits. Is that fair to say? So 0.4 over 0.6, how do I get the 0.4? Well, it’s the difference here, and that’s where I’m growing from. So 0.4 over 0.6 is two thirds, but I only increased my gains from three to four. So that’s one over three, that’s 33%. So the goal for me then is to become more profitable, not worry about accuracy. And how do you know whether you you’re in a winning trade? You can already tell that’s the beauty of it.
You don’t have to worry about the accuracy thing at that point because you’re already in the winning trade. You see, it’s easier to just stay with what’s working than have to worry about coming out and putting yet another indicator on your chart. What can you do? Well, we talk with Brian Shannon. You can look at key points and do some anchored vw. You could check the trends over multiple timeframes. I would definitely look at weeklys and monthlys because that’s where definitely weeklys and dailies, because that’s where the material data are in the longer time series, short-term data, intraday stuff, people trading 65 minutes, four hour bars, I get it. The thing is, is that no matter how you slice and dice the intraday stuff, it’s much more random despite the patterns that you think you can see, all right? Whereas if you’re looking at weekly breakouts, that’s much more significant because there’s so much other time that can be employed into the data to really screw it up.
So if you see something evolving on the weekly charts, now you can downtime it to dailies or maybe even intraday to see where the specific levels are. So when people say to me, I want to be more accurate, I always kind of start to think and say, well, there’s a lot more too. Trading profitably in calculating where you’re trading edge is by looking at the results. That’s why I’ve said from day one, don’t sit around and think about it. Don’t read another book risk five bucks a day. I don’t care what it is, but put some real risk on and test your ideas and make sure that it’s with real money because you’re going to behave differently when real money is at risk rather than paper trading. And it’s not to say that some of you can’t treat the paper trading account, it’s real money.
Maybe you can’t. But I do know one thing is for Dam shore, when you’re starting to lose real money that you had to work for, and you’re still in the spot where you’re like, okay, there goes 10 pair of Air Jordans, or there’s a weekend away that beautiful Mount Air Lodge or wherever you’re going to go, you start to internalize that, and now the feelings become much more real. You see what I’m saying? So that’s why I say you’re better off trading real money and risking whatever, some tiny not measurable amount of money because at least it’s going to attach real feelings to you. And you’re an emotional system as much as you are a trading system. That’s absolutely true. Now, once you have all this data, you can do some really funny things because you might have, when I say funny, I mean interesting in the way I use funny here.
What’s funny is once you get the expected value, here’s your expected value. Now you can go back and say, okay, well what was my goal? Right? Because you don’t want to, when you think about trading any other endeavor, it’s like what is it that you want your money to do for you? And I don’t mean I want to make money, but once you have accumulated all that money, okay, well, I want to grow it. Okay, great. At the end of the day though, there’s a point where you’ve accumulated enough money to more than cover a very high quality of life. So that’s what I’m getting at. What’s the point of growing your money? What does that do for you? There can be small things along the way. My self-esteem goes high. I know I can succeed at something that most people fail that can make me feel good without being shot.
And Freud, I can make my hour own hours. I can be my own boss. I can for the way that I trade. I can do this over several days early in the morning before work, and then I can offset or put orders in during my lunch hour or what have you, for managing my risk the rest of the day. There’s a million ways to do it depending on what your holding period is, of course, and whether or not you’re looking at using or trading levered instruments. So I would say in a long-winded way that focus on how to increase your average win, because you can do that without having to have a higher winning rate, because you’re al, if you’re already in a winning trade, you can squeeze more money out of it by staying in it longer. And that might mean holding it overnight.
I’ve already done that study and I showed you that you actually get paid quite handsomely for having risk overnight and over the weekend, you see, but I wouldn’t let you know the lack of a goal, the lack of a goal to me. We’ll talk about this maybe tomorrow, if you get lazy with yourself, it just means you’re delaying gratification or you’re not really ready to hit your goals yet. So that could be your subconscious. Why is that happening? Are you not worth it? Right? Are you afraid to really kick in? What would happen if you actually hit your goals is that very, sometimes that’s very scary for people. You see what I’m saying? So it doesn’t matter to me. If you’re into reversals or you’re day trading, or you’re a short seller, or you’re doing option spreads or commodity spreads, or you’re doing any type of directional trading, you’re only going to get the real data that means the most from real trading.
The hypothetical stuff is interesting, but the truth is, is that very rarely do the things happen in the laboratory. Do they work out in real life? It is important to give you an idea because you can, if nothing else, see that your system would’ve made money one and two, you can calibrate your emotional constitution with those very rules because if you start to trade and you think, well, no, I’m not going to have draw down. It’s not at least the way other people do because that’s just not me. I don’t do draw downs and then, okay, fine. But if you looked at your rules and you followed them objectively, these systems do like these simulators, right? It’s forced objectivity it. You can’t go back and say, oh, yeah, well, that was a big loser. I would never really have taken that trade. You don’t get to make those decisions because the computer just looks at the data and says, the criteria is met. We’re going to add the risk according to this position sizing algorithm. And then there you have it.
It’s important though also, or in order for you to grow your average winner, you have to be absolutely regimented and militaristic about taking your average and your small losses. So that has to be locked in because the minute you give yourself permission to say, I bought something, here’s the chart, dot da, da. Got the breakout here. I got it at 18, my stop was at 17, it’s at 20 now, and then it comes back on me. And then when you find yourself at $17 and 20 cents, you’re like, oh no, I’m just going to make it 16 because I don’t want to get knocked, knocked out and have the thing go back up. I’ll feel like an idiot. But what happens is if it trades 1720s through 17 down to 16, the way I would look at this and don’t, I’m not using any data, is that sixteen’s going to bring 13 before it’s going to bring 20 again.
And you can see that. You can see when tops fail, that oftentimes happens, is the thing comes back, takes out a bunch of folks, and then there you have it and it’s lookout below. So you always want to make sure that no matter what you’re thinking, even if you have a hunch that the instrument’s going to come down and rally back up, it doesn’t matter. You can only manage risk in the ever-evolving moment of right now, I can’t manage my risk based on what I think is going to happen next week or into May when earnings starts to kick in again, when earnings are getting reported. If the price is going against me now, and I’ve already determined what my position size is, there’s a set spot where I have to get out and you need to own it right here. And that’s the key to making money, is to keeping that number small.
Because what you don’t want to do is it put yourself in a spot where your average wind can go up, but then you get super lazy on where you’re putting your protective stops. And so at the same time, your average winner goes up, but so does your average loser. Why? Well, because you had that one big outlier trade, and then you do yourself a disservice by saying, well, yeah, that was just a flyer. I took it. I admit I was wrong. I lost money, but I don’t include that in my results. Well, now your numbers don’t have any integrity, right? Because you’re kind of making stuff up on the fly, and I don’t think you’re being honest with yourself. So before you start worrying about batting average and your winning percentage, I would say the easiest way to have a higher expected value, which to me is the goal, not how frequently you win, look to increase your average win.
And that can mean staying in trades longer, scaling out of your winners at key times, and then putting protective stops below the market on the remaining position so that if it does reverse, you know, don’t get knocked out for heavy losses, right? That’s a very interesting way to look at the math behind trading and why is it? Why does it work? Cause this here represents what your trading edge is. Once you get this number down, it’s something really cool happens in that you can look at, say, Kelly criterion or otherwise, and now you can see, okay, well if this is the expected value of a trade and I know I want to grow my money fivefold, I want to turn a 10 K into 50 K or whatever, the number doesn’t matter, I want to take a million to 5 million. Well, based on your own behavior, what the expected value of a trade is, a couple things happen.
One is you can say, on average, I’m making my expected value even on the trades that I lose. And that’s why it pays you to put on every trade effectively and spiritually, is that you have to put on every trade. Because on average, when you have an edge and you follow your criteria, right, the expected value’s not going to change from one trade to the next. If you change your bed size, yeah, absolutely. If you change where you put your protective stop, that’s going to alter everything so that the rules have to be locked in and written in stone. But if the goal is to make more money, I would say yeah, be mindful of checking out and testing where you can get better winners by altering your entering criteria. But I wouldn’t go nuts, and I certainly wouldn’t look at overlays and indicators because I’ve already proven to myself that they don’t work.
So I’d save you the time if you want to go do the work yourself. It’s a very enlightening experience. But I think increasing your average winner is might be the easiest way. Then once you figure out what your edge is and what the expected value of the trade is, you can use Kelly criteria to see, okay, well based on these numbers, here’s my optimal position size. And then having said that, you can figure out further in order to hit your goals, you’re going to have to put on a certain number of trades, and you might be like, man, market’s stalled. There wasn’t really a lot of good opportunities this past week. I’m going to need to put on 10 or 20 trades, whatever the number might be. I might have to put on tw 20 trades a week because the system, after everything is said and done, suggests that I have whatever, 250 trading dates and I need 500 trades. So whatever that number comes up to be, two a day, maybe that’s it. Maybe it’s 20 a day. So now you can say, okay, well based on the practical, there’s not that many opportunities for me given my trading style, but at least now you, you’re dealing with objectivity and you’re looking at the numbers so that this way, if your count isn’t growing, at least the reason why, and it probably doesn’t have anything to do necessarily, or at least solely with the winning percentage.
You see what I mean? So it gets kind of deep, but this is all very, very important because you’re winning and losing percentage come from calculating position size, entering your orders, and letting the market come to you. The average winner, average loser is a ratio that you create also based on your own behavior that you’ve observed. And so if you want better results, then you can absolutely have better tactics for say, taking winners or staying in winners longer, or maybe even adding to winners. Like all of that’s doable. That to me, is much easier than trying to find the most accurate system.
Cause I would say embrace the uncertainty of making and losing money. Just use your protective stops. Once you’re in the position, use buy stops above the market to enter long positions. So this will motion or the need to chase, which is lethal, and then add it all up. Because when you then look at where your edge is at and how you’ve created, now you can set goals to me are much more realistic because you can see based on your own behavior, what you’ve deliberately done, intentions equal results. So that’s why I don’t think this is terribly difficult. It can be difficult if you make it difficult, otherwise it’s pretty simple. The math is not terribly difficult. But once you have the math, then you could really set better goals because you’re like, okay, if I want to grow my money five or 10 times my account size, I don’t have enough trades on to get there.
One, I might have to increase my size. So that means what you have tighter stops, you give it more room. Are you going to invite bigger drawdowns? So now you’re kind of, again, you’re carving it out of stone. David was already in there, Michelangelo just said him free. Now you’re kind of doing that with your own trading, and it’s not complete guesswork. Now, if you go back and watch another video I put up about how to use scale up, you can see why people just going from trading ones and twos to say fives to tens is reckless because your account isn’t growing in proportion with your position size. So you’re actually increasing your risk in a way that hasn’t been scientifically tested to help you maximize the results that you can see from this very equation. Again, then you can go use the Kelly Criterion Kelly formula to help calculate what’s your optimal position size, and then you’re off to the races based upon what you want your target rate of return to be.
So then the whole thing isn’t just a role of the dice, it’s much more scientific, but then you have to stick to the behavior because the behavior predicts where you end up. You can sit and do the math all day, but the reality is, is that if you don’t stick to the rules, then what’s it all for at that point? Because you’re not being true to the model, and it’s the behavior that predicts where you end up. So you have to execute your trading rules, your model, your system, you can call it. It’s the same thing to me, you know what I mean? So this is hopefully very, very insightful for you on how do you actually improve your trading and making money. I would not worry about accuracy. I would worry about increasing the expected value of a trade, which again is to me easier.
How do you know? Well, because you’re already in the winning trade, just increase your holding period. You’ll have to deal with the emotions that go with that. But that to me is a lot easier than trying to test indicators and moving averages or otherwise to find a more accurate entry system. Okay. Anyway, thanks very much for the comment. Appreciate please like and subscribe and always give me comments. Let me know what you think because I can come up with more material like this that’ll hopefully be very valuable to you and help you accelerate your learning curve. All right. Thanks for being here, folks. I’ll see you tomorrow.
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