Saturday, December 09, 2017

Trading Psychology Challenges - 8: Complacency and Overconfidence

Unless you as a trader operate with a consistently high hit rate on your trades--far and away the exception in directional trading--then you're likely to experience sequences of winning and losing periods simply as a chance occurrence.  The noisiness of markets, which means the presence of flows from different participants at different times, ensures that good ideas will sometimes not work.  A major problem for developing traders is that they fail to distinguish between periods of losing money and periods of trading poorly.  This leads them to continually change their trading and risk taking, eroding their probabilistic edges.

There is a flip side to this problem, however, and that is allowing strings of winning trades to skew forward risk taking.  Falling prey to the "hot hand" fallacy after a winning period, traders falsely assume that they now have a much larger edge and expand their risk taking.  They size positions unusually large and/or take many more positions.  As a result, when the inevitable losing trades occur, these wipe out large amounts of the prior gains.

It is not unusual to see traders oscillate between sloppy and complacent trading after winning periods and overcautious and risk averse trading after losses.  This means that they are most likely to lose when they take more risk and most likely to follow rules and trade carefully when they take less risk.  This recency bias ensures a downward skew to P/L over time.

Complacency after winning periods can show up in other ways as well.  Traders can become less focused in their research and preparation following profitable runs.  They can also let positions stay on their books without careful periodic review, allowing those "stale" positions to surprise them by reversing on unexpected news or flows.  

The key to avoiding overconfidence bias is to actively view winning periods as risks to future trading.  This is counterintuitive, as human nature is to feel good about succeeding.  If, however, you are actively reminding yourself that wins can lull you into carelessness, then you have an effective prod to double down on the essential elements of trading process.  An exercise I've found helpful in this regard is to visualize that the recent gains have instead been recent losses.  How would you be preparing for the day in that event?  Would the trades you're contemplating when you've made money also be ones that you would take if you had experienced losses?

A common mistake at trading firms is to allocate capital/buying power to traders after winning periods and reduce capital/risk after losses, when such stretches of losses and wins are entirely expectable given the trader's historical Sharpe ratio.  It is not at all unusual to see a trader wipe out prior gains by meaningfully bumping up risk taking after a profitable period.

Ultimately, traders become vulnerable when their feelings about themselves and their work are tied to short-term returns.  As I noted in the 2.0 book, one of the greatest strategies for avoiding recency bias is to have sources of happiness, fulfillment, and energy outside of markets and thereby ensure that trading fits into your life and not the reverse.  We become vulnerable when our recent returns dictate our current moods.