GTO stands for “game theory optimal”. Game theory applies to many different disciplines and the ‘GTO’ term has become popular in the poker world during the last decade. GTO is something every trader should understand.
Over the years, it has come to my attention that the majority of people who try trading have no background in game theory. If I had to pick the number one reason most people fail, imho, this would be it.
I was playing poker with my dad and his friends when I was 8 years old. I played all kinds of card games and board games and video games during my childhood. This helped immensely when I was studying day trading. The people who tend to struggle the most with trading are those who have little to no experience with gaming of any type.
Day trading is a poker game being played in auction format. Traders at firms which move a lot of size try to hide their intent in the same way a poker player tries to disguise what cards he’s holding. A trading firm will slowly accumulate a long position and then, when resistance to the upside seems weakest, it will rapid fire buy orders into higher prices in an attempt to start a chain reaction. When other buy orders begin hitting offers at higher and higher prices, the firm starts scaling out of its long position. It creates the move and then profits from it. The firm outplayed the other players.
I use a term in my teaching: “macro to micro”.
You first need a feel for the macro picture and then you fine tune entries and exits based on the micro picture.
If every time a market makes a new high, it quickly pulls back but not back too much and then makes new highs again, the macro picture is telling me I need to keep a long bias and look only for long trades while that’s happening. There is no point in trying to pick the pullback spot and short into an upwards trend. I would most likely just be run over repeatedly. From a micro perspective, I look to take short-term long trades with the runs higher and try to catch momentum. Then I exit at the first sign of a pullback. Rinse and repeat till it stops working. I’m adjusting my strategy to the game as it is currently being played.
If price is moving back and forth in a very erratic fashion and there doesn’t seem to be any rhyme or reason to it, the macro picture is telling me to not be involved. There is no micro picture to contemplate because there is no trade to be made in that situation.
Looking at it from a game theory perspective, the first question is whether or not to trade. If trading seems to fit the scenario, the second question is how do I extract as much as possible from that scenario.
With day trading, you are trying to determine what the most likely scenario will be during the next few minutes. What is the macro telling you? During those moments when you have a read on the situation and are fairly certain you’re on the right side of a move in a big way (i.e. you are long and the market just keeps rocketing higher), you want to extract as much from that situation as possible. Increasing size and continuing to buy more till the momentum stops may be the play.
In a different situation when a market seems to be somewhat rangebound but isn’t exactly holding specific levels, trading may be warranted but scaling up on size most likely is not. The micro play there may be to ease back on size a little and just go for quick, small wins.
I’m always assessing the macro. Based on the price action and liquidity, what is the most likely scenario? I anticipate the future by having an understanding of the macro. I try to increase the amount of money made and reduce the amount lost by having an understanding of the micro.
*Note: Do not average into losers. Nearly everyone who tries it suffers a net loss over time.
Product selection is also a part of the optimization. Some markets can be easier to read than others. Experimenting with different markets is a good idea. Watching multiple markets for an extended time will show you the pros and cons of each.
A person should not be dead set on only trading one product when starting. It’s fine to specialize in one product eventually but a person should learn the nuances of several markets before deciding which one may fit his style the best.
Sometimes products change quite a bit in terms of liquidity and volatility. It’s possible that one product may be an excellent trade for six months and then much more difficult the following three months. When it becomes more difficult, looking at other products which may be easier can be a good idea.
Most people who contact me are determined to only trade the ES (or now the micro ES). They have no idea how difficult it is trade the ES profitably. It can obviously be done but there are other products which are frequently easier to read and cost less to trade. I’ve made a lot of converts who dumped the ES to trade treasuries and liquid stocks/ETFs.
Here is a poker analogy which should help you understand the core idea of GTO:
I’m playing a 5/10 no-limit Hold’em game. I’m dealt 7-2 off-suit which is the worst starting hand possible. A guy to my right raises. I fold. GTO dictates never playing that hand. It’s an easy decision same as not placing a trade when the market is completely dead nor taking a trade and holding that position into an economic number release. Both are bad ideas.
I’m dealt 10-9 of hearts. One person raises to $40 and I will be the last to act the entire hand. Position in the hand is important. I call because I know the guy may give me some money if I flop a good hand such as two pair and he has something like pocket queens. That’s the macro.
The flop comes A-J-2 with two hearts (first three communal cards). I flop a flush draw. However, my opponent then bets $250. GTO dictates that I fold the hand. Yes, I may make a flush if I call but the odds are against it and there’s not much money in the pot and if I make the flush, my opponent will probably think I have the flush and not give me anymore money. Plus, if I don’t make the flush on the turn (4th card dealt), it will probably cost me another $500 to see the river (5th and final card dealt) and I still may not make the flush. Pot odds and implied odds are wrong for a call. I fold. That’s the micro.
I’m dealt 10-9 of hearts. One person raises to $40 and he’s the gambling type. I call. The flop is 6-7-8 all different suits. I flop the best possible hand (straight). My opponent bets $200. This is the macro.
Now…the micro is figuring out how to extract the maximum amount of money from this hand. If I raise, he may fold. If I just call, he may bet again on the turn. Let’s say I just call and the turn goes check-check meaning neither of us bets. Once the last card is dealt, I still have the best possible hand and cannot be beat. He bets $300 (presumably as a bluff or he thinks I have nothing since I didn’t bet the turn) and he has another $1000 in chips in front of him. I am now trying to determine how much of a raise he will call.
Will he call a minimum raise of $300? Or will he be supsicious and think it looks too much like I’m trying to get a call? If I raise to $1300, will he think I’m bluffing and put the other $1000 in the pot because he thinks he has me beat? Or does he not want to risk it? What if I raise $500? It’s just enough to look like I may be bluffing and his entire stack will not be lost if he calls and loses.
If I can get all $1000, I want it. But I also don’t want to bet too much and get none of it. This is game theory.
You must first find an edge of your own. This means finding trades which yield a better than random result over time. Then you must make the least amount of mistakes possible in order to preserve the money made on those trades. This brings me to the second lesson of this blog.
There are moments when you know you should not be trading and you trade anyway. You can’t do that;) I’m going to put it in numbers which will show you just how much of a problem this is.
Let’s say you are making trades where you either win or lose $50. Risk $50 to make $50. Once a week, you make a stupid trade you know you shouldn’t make and lose the $50. That is $200 a month. You are giving away $2400 a year for no reason and that’s on one contract. Now scale that.
In that same scenario, if you’re a ten lot trader and can eliminate that one stupid trade each week, that adds another $24,000 to your bottom line at the end of the year. You have to think about these things. The mathematics are just as important as the setup strategies.
If you’re up $400 on the day and take that $50 losing trade and still finish up $350, you think, “I still finished up $350 so it’s fine.” That is flawed thinking. The thinking should be, “That was idiotic and trades like that cost me thousands over the course of a year.”
Which brings us back to the only two rules in trading:
Trade what you see.
Don’t be an idiot.