Lesson 8: A 3-Step Method For Late-Start Trades | The Absolute Beginner’s Guide
I have written previously on what to do when you show up late to a bubble. That’s the general background for thinking about risk.
This piece focuses specifically on how I make decisions about “traditional” bubbles like Bitcoin (I outline the three kinds of bubbles here). What I’m going to review is how to think about individual trades and what you should be shooting for. I follow a simple 3-step method. Then I’ll apply that to Bitcoin itself.
Let’s start with a little arithmetic.
Good Reward / Risk Ratios
To understand how this works, think of trading as a series of bets placed over time. Assume you are going to make multiple bets, wagering $100 each time. What you’ll want to know is simple. What reward to risk ratio do you need to make money consistently?
If your reward to risk ratio is 1 to 1, so that you stand to gain as much as you stand to lose, and your probability of reward is greater than 50% then you will make money. To illustrate, think of it this way.
- Bet 1: Win $100
- Bet 2: Win $100
- Bet 3: Lose $100
- Bet 4: Lose $100
See, that was exactly 50% right and you ended up even. If you had better than a 50% chance of winning, and you bet enough times (4 isn’t enough), you would make money long term.
If your reward to risk ratio is 2 to 1, then so long as you have better than a 33.3% chance of a pay-out, you’ll make money long-term. To illustrate, think of it this way.
- Bet 1: Win $200
- Bet 2: Lose $100
- Bet 3: Lose $100
See, if you continue this process with a better than 33.3% chance of winning, you would end up winning money.
Inversely, suppose that you have a reward to risk ratio of .5 to 1, but a probability of winning that was better than 66.67%. Then you would still make money.
- Bet 1: Win $50 (in addition to keeping your original $100).
- Bet 2: Win $50 (in addition to keeping your original $100).
- Bet 3: Lose $100
In this scenario, then, your reward to risk ratio was bad, but because your win ratio was so high you still broke even. Even at the .5 to 1 ratio, as long as you win more than 66.67% of the time you will make money.
To combine the ideas, you will make money if you have a strong reward to risk ratio with a high probability of winning.
This is why the art of the bubble makes sense. Bubbles pay off a ton. And the Basic Economic Cycle indicator that I use, and which subscribers get information from, has better than a 70% win ratio.
But What About When I’m Late To A Bubble?
It’s pretty easy to see why, when you catch bubbles early, you will make money. That’s why my 782% return from last week on cannabis stocks is pretty normal for a dedicated bubble trader.
But when you’re late to a bubble, you need an extra guideline. Here’s how I think about it.
When you are late to a bubble, your trade will make sense as long as you have a 1 to 1 payout ratio.
The reason is that, after joining late, you are unlikely to be in a position to have better than 50% probability of success. There are just too many unknowns.
The Basic Economic Cycle indicator, and the industry-specific indicators that I use, will tell you when you must sell. But they’re not specific enough to tell you when to buy after the beginning of a bubble.
To figure out if you should buy, you need to think in terms of these risk-reward ratios. Just ask yourself: does this trade give me at least a 1 to 1 ratio with a 50% or better chance for winning?
You can answer these questions by looking at history and price momentum. Let’s make all this more concrete with a Bitcoin case study.
Case Study: Bitcoin With All-Time High of About $50,000
Right now, Bitcoin has an all-time high of just a little under $50,000.
Momentum indicators would tell you to sell when the price of Bitcoin drops below the 200-day simple moving average (SMA). It’s not a great indicator but it is a clear one.
A slightly better indicator I developed emerges from an historical review of all of Bitcoin’s pull-backs during its bubble runs. What counts as a “pull-back” is not super clearly defined, but using common sense, I found that there have been 37 of these and that makes the sample set statistically significant.
While there are some exceptions, if Bitcoin drops more than 36% from an all-time high, it is likely that the bull-run is over. If it doesn’t drop that much, then just keep your money in. That’s how I do it at least.
So whenever you start a position in any bubble run, you just need to be aware of your risk. Let’s say that you bought in at $46,000 and will sell if the prices drop over 36% to $31,600. In that scenario, 31.3% is your downside risk.
What’s the upside? Well, a lot of people are thinking that Bitcoin could break $100,000. At $88,000 that would be 10x the beginning of the run and that would represent the smallest bull run in Bitcoin’s history by a factor of 6. So let’s assume that $88,000 is a fair target (if it goes higher, then great). Your upside target, then, represents a 91.3% gain.
Now apply the analysis from the reward to risk section. You want a ratio greater than 1 to 1. Right now you have a 91% to a 31% reward to risk ratio, just shy of 3 to 1 (2.935 to 1 actually).
Our estimate on the top side is based on history with a healthy margin of error. The 2017 bubble ran up more than 62x from when it first crossed the SMA 200. We’re basing our estimate on a bubble 1/6th that size.
Let me give you a little summary of the ideas:
- Upside: 91% with better than 50% probability based on history.
- Downside: -31% with less than 50% probability based on history.
In fact, as long as you think Bitcoin could hit $62,000, then you still have better than a 1 to 1 reward to risk ratio.
Concluding Thoughts
My point here is that a little bit of arithmetic will tell you whether it makes sense to buy into a bubble if you are late. In summary form, here is how I do it.
- I check to make sure that the macro-environment is good (the Basic Economy Cycle indicator is at least a Yellow 3 on a scale of 1 to 5).
- I check to make sure that the industry indicator is good, ideally a Green 5.
- Then I do a reward-risk analysis and make sure that I’ve better than a 50% chance of reward (in part secured by the above two steps with a little bit of historical analysis) and that the payout is 1 to 1 or better.
If the trade meets those conditions, then I buy and stick to my sell strategy.
With that process, you should be able to trade bubbles successfully over the long term. Unlike others, I’m not trying to sell hype. The plan here isn’t to get rich in one trade or one year. That takes a lot of luck. I’m a reasonable trader who prefers to keep his gambling in Las Vegas where the booze is free.
This approach helps me trade well and it’s pretty manageable.
The long view on Bitcoin is encouraging anyway. It’s likely to be worth more than $500,000 at some point in the next 5 years, so you’re probably going to be fine just holding it even if you buy at the top.
Disclaimers
General financial disclaimer: This post is provided for entertainment purposes only. I am not giving you financial advice and I am not a financial advisor. You should expect no financial returns one way or another based on my statements. These points hold equally for any statements that could be attributed to The Art of The Bubble or any related business entities. If you decide to buy or invest in anything, then your returns and potential losses are your own. No statements about taxation are taxable advice and you are encouraged to consult your own tax professional. You are also encouraged to do your own due diligence before investing in anything.
Specific disclaimer: I own more stocks and bonds than I discuss here, but they are not relevant to bubble trading. Anything that is relevant, I let you know my position in them through the charts above.