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Trading Psychology Techniques - #10: Overcoming Overconfidence

I have found that runs of winning trades are just as dangerous for traders as runs of losers.  It is very common that we anchor ourselves to our most recent returns, trading too small after we lose money and too large after wins.  This means that we're often too small when we turn our trading around and too large when we encounter inevitable losing trades.  The overconfidence dynamic is common among momentum traders who become more confident in the trade as it goes their way, adding to positions that have already moved in their favor.  This greatly changes their average price and makes them vulnerable to normal reversals.

The mistake traders make in anchoring themselves to recent returns is a failure to recognize randomness in the outcomes of a few trades.  A 50/50 win/loss ratio for an active trader means that strings of four losing trades (or days) will inevitably occur.  If every such series leads to a loss of confidence and a micro-managing of the trading process, it will be difficult to sustain consistency.

On the other hand, it's inevitable that such a trader will have strings of winning trades or days simply by chance.  If this leads to overconfident thinking and a doubling down on risk-taking, the trader will quickly give back those gains.

A great exercise to combat overconfidence is to visualize the scenario in which it's January 1st and you are neither up money or down money.  Would you take the trade that you're contemplating if your P/L was flat?  If so, how would you size that trade?  How much would you risk?  If the trade is truly a good one, you would take it on January 1st and size it reasonably.  If the trade is more marginal--the result of overconfidence--you would be much less likely to put it on with a flat P/L.  By vividly imagining a flat P/L, you help yourself get flat in your head, reducing emotional pulls.

Another useful technique is to actively rehearse, prior to putting on the trade, what you would need to see to tell you the trade is wrong and that you need to exit.  When we're overconfident, we often don't process adverse scenarios.  By making such processing an active part of your preparation, you give yourself a more balanced perspective during the life of the trade.

"This, too, shall pass" is a great mindset after periods of both losing and winning.  Imagine the surgeon about to operate.  You don't want that surgeon to be wildly excited and overconfident, and you don't want that surgeon to be fearful and hesitant.  Each trade is a kind of surgery, and the best you can do is stick to the best practices that have produced favorable outcomes in the past.

Further Reading:

How Overconfidence Derails Our Trading

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