Saturday, July 22, 2017

Why We Overtrade and Why We Miss Opportunities

So many psychological problems of trading boil down to underaction, failing to act when it is appropriate to do so, and overaction, taking actions that are not warranted.  Undertrading means that we fail to "pull the trigger" on our ideas.  Overtrading means that we trade outside the range of our ideas.

As Gandhi's quote suggests, our actions express our priorities.  The trader who fails to act is very often prioritizing preservation of capital and avoidance of risk and loss.  The trader who acts excessively is prioritizing gain and avoidance of "missing out".

What I find in working with traders is that underaction and overaction occur in a specific context. Very often the trader has figured out the idea that would have them long or short a market or stock. What they have not explicitly outlined is the specific set of conditions that would have them act upon this idea.  In other words, traders have an idea, but not a clear "setup" criterion that would have them execute that idea.

In the absence of a clear entry or exit signal, traders are left with ambiguity.  That ambiguity is the fertile ground in which those psychological priorities--avoidance or risk, fear of missing out--grow and become dominant.  It is necessary to have sound ideas with edge to succeed in trading, but having great ideas is not sufficient to bring success.  One also must know how to implement those ideas.  Without a sound basis for implementation, ideas cannot come to consistent and optimal fruition.

To be sure, we see the opposite problem as well.  Traders will grasp as "setups"--patterns of price movement--as ideas and trade these without any objective verification of having a probabilistic edge in outcomes.  "Selling is holding at the X price level" may be a useful observation, but it is not a plan and in itself confers no edge.  A common problem among daytraders is such eagerness to trade and make money that relatively little time is spent researching ideas that are actually worth trading and that have the potential to make money.

Once we distinguish between the idea we're trading and our plan for executing that plan, we're in a better place to figure out when we need to work on our ideas and research (i.e., trading the wrong ideas) and when we need to work on the trading of those ideas (i.e., faulty execution of our ideas). Very often, we overtrade and fail to act on valid opportunities simply because we have not been explicit about the idea we're expressing and how we are expressing it.