Cures for a Trader's Optimistic Bias

Over the past week, I’ve spoken to a number of new traders who’ve been having a rough time. Some have not experienced the level of volatility we’ve seen in the markets lately, and this has shaken them to the core. Many folks are baffled as to why their bulletproof strategies are now fallible. Anxiety has been running rampant, and I’m no longer hearing talk of this market going to the moon. Rather, there’s been much gnashing of teeth and fear of a different destination.

Being the heavily grizzled (and graying) veteran I am, I can’t help but chuckle a bit at the “sky is falling” perception of some. I try to assure them that history shows markets can get a heck of a lot more volatile than the recent price action we’ve seen and remain unpredictable for months and months. This doesn’t seem to help…much.

All kidding aside, I can empathize with these new traders because I too was once a noob. I have been in their shoes, and I know what they’re going through. Having the benefit of trading options on the trading floor for 15 years, I’ve experienced several boom-and-bust cycles and the accompanying rollercoaster emotions. Learning about some of the psychological aspects of trading can help temper your emotions during trying times. The goal, of course, is to increase your confidence and subsequently improve your win rate.

Trading Overconfidence

A surefire way to cure a trader’s overconfidence is for he or she to go through a period of market instability and high volatility. Subjectively, traders must think of themselves as skilled “enough” to match their prognostication ability against the markets. Often through practice and skill, a trader can put together a decent win/loss record over a couple of months.

That’s great, of course, but sometimes these optimistic affirmations can lead to a tragic case of overconfidence. If you’re not careful, such optimism can cloud your judgment. When traders believe things will always work in their favor this becomes an optimistic bias, which can lead to complacency. Having been in this situation before, I’ve learned a technique that helps keep me grounded, tempering a natural inclination for overconfidence.

Pessimism Isn’t So Bad

Fortunately, in my early days as an options trader, I had an innate ability to snatch defeat from the jaws of victory and did so more than a few times. I believe this helped me temper any optimistic bias. It calibrated my way of approaching markets and trading to one of assuming something would go wrong with my trade.

When I expect to lose on a trade, it forces me to seek to find out how it may occur. This helps improve my judgment by making me more mindful of the items on my pre-trade checklist (technical analysis, news, dividends, volatility levels, etc.). When I expect a trade to go south, I set strict levels from which I will exit a losing trade, limiting my loss to a bearable amount. I tidy up my trading systems and processes that may have gotten a little loose and fast. These are very good things to do periodically.

Optimistic Bias

Another benefit of pessimism as a cure for optimistic bias is that I generally trade less when I am wary of losing money because I am more mindful of what can go wrong. My style of trading is not one of a day trader. I usually trade a term structure that goes out at least one or two weeks at a minimum. But when I used to get on a hot streak, I would find myself trading like a day trader. All of a sudden, I’d be flipping gamma and picking up new additions to my watch list every other day. Overconfidence, paired with ambition, would lead me to assume I would earn more if I traded more.

What I determined over time is that when I was trading more and more, I was developing decision fatigue. I was entering trades for the wrong reasons and/or not enough of the right reasons. I was succumbing to my innate compulsion to make money and not paying attention to logic and reason with regard to choosing the best trades. By getting out of my sweet spot of expertise and taking on lower probability trades, my win rate would ultimately suffer.

Post-Action Trading Report

Without going back over my trades, I would never have recognized the err of my ways.  I’m grateful I was taught early in my trading career to conduct a daily P&L analysis and maintain a record for future reference. It is important to be able to recognize trends to identify which types of trades are working better than others.

New students often find this a rewarding endeavor because it uncovers their strengths and points out areas where they need improvement. I hear again and again how they would not have determined these things without going through this process of analysis. Spend the time; it’s worth it.

Sample Size Matters

I feel it’s important to remind everyone that sample sizes matter. Keep in mind that to identify a trend, you should include dozens of trades in your analysis. Less of a sample size is subjected to inevitable discrepancies and is ultimately deficient due to the Law of Small Numbers. This “law,” simply put, states that small samples generate a higher frequency of extreme observations than large samples. Unless you have dozens of trades in your sample, you will get too many false positives, which will skew the accuracy of assumptions you draw.

Final Thoughts

It’s important to recognize just how big of an impact the psychological aspects of trading can have on your success or failure. You can benefit immensely by heeding the warnings of experienced traders who share their pessimistic wisdom. However, you must be able to truly listen to not succumb to a case of tragic overconfidence.

Joe Leska, Market Taker Mentoring

Trader Education