Trading Psychology 2.0 - Steenbarger Brett N.

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of his trading were needed. What I found in breaking down his trades was that he was losing more on the short side than the long side – and this was in markets that had been in longer-term uptrends. Subtly, Maxwell was trying to prove himself by making himself into a contrarian. When he saw that this also was acting like an idiot by swimming against the tide, he became much more open to using simple gauges to stay on the proper side of the market. For example, he defined strong, neutral, and weak markets based on early readings of how the market traded relative to its volume-weighted average price (VWAP), preventing him from fading the very strong and weak markets. By expanding the useful patterns he looked at, he was able to leverage his pattern recognition strengths.

      He came to me with problems, but it was his good trading that generated the solutions. Once Maxwell found a way to bridge his fast trading skills with the emotional driver of his trading, meaningful change could occur.

      That is the takeaway: We cannot change if we fail to tap into those emotional drivers.

      The Perils of (Over)Confidence

      We know how to plan for change in our trades. So why do we rarely get to Plan B in our careers? The cases of Chris and Gina and Maxwell illustrate that our core motivations and commitments can lead us to act in ways that are ultimately self-defeating. Years ago, I worked with a very successful professional who experienced considerable rejection both in childhood and later in a bad romantic relationship. She developed a commitment to self-reliance, determined that she would never be hurt and vulnerable again. As a result, she moved forward rapidly in her career – and she remained lonely, unable to sustain long-term relationships. Her commitment to independence made it difficult to sustain emotional commitments. That couldn't change until she recognized, in her own experience, that she could depend on someone she cared about and still remain independent. A turning point in her therapy occurred when she did not perform a homework exercise I had suggested. It took a while to get her to acknowledge that she was uncomfortable with the exercise and didn't want to go down that path. Instead of exploring her “resistance” to the exercise, I congratulated her on standing her ground and acting on her instincts. We then jointly crafted a different exercise.

      What helped spark the change was a relationship experience. She could depend on me —and be independent of me. Sometimes change begins in small ways, in a single situation, a single relationship. And many times it begins in ways other than talk.

      It takes a while to get to the change point, however. Those anomalies – the consequences of doing the right things and now getting the wrong results – typically have to accumulate before we contemplate doing something different. It took that young lady quite a bit of loneliness before she was willing to reach out to a counselor she could rely on. After all, when our approach to life or trading pays off in the present, we build confidence in what we're doing. That confidence can become overconfidence. We behave as if we've found a permanent life solution, as if we can continue on in our present mode and never get hurt again: never live in a troubled household, never have another losing year. Maxwell wasn't just confident about his trading during his money-making years; he was so confident that he felt no need to analyze his wins and losses or adapt to changing market conditions – until the profits stopped rolling in.

      Author Robert Anton Wilson has noted the similarities between those who are totally convinced and those who are totally stupid. He also pointed out that our convictions make us convicts: We become imprisoned by our belief systems. As we saw earlier, a trader with absolute conviction in a statistical model could face quite a loss when the present idiosyncratically deviates from the past. Commitment looks like admirable discipline – until it becomes a straitjacket.

      Behavioral finance research finds consistent confirmation and overconfidence biases among investors and traders. A confirmation bias occurs when we selectively process information that supports our views. Overconfidence biases lead us to overestimate the odds of an anticipated trade or market scenario working out. An interesting study of South Korean investors from Park and colleagues looked at their participation on online message boards. As you might expect, their processing of information from message boards reflected confirmation biases: Traders tended to read posts that most agreed with their views. Interestingly, those with greater confirmation bias also displayed greater overconfidence in their ideas, tended to trade more often, and tended to lose more money than did peers with lesser conviction. Scott, Stumpp, and Xu reviewed the literature in 2003 and concluded, “A considerable amount of research suggests that people are overconfident, and that investors in particular are overconfident about their abilities to predict the future” (p. 80). Moreover, they found that such overconfidence biases are present across a variety of markets and countries.

      Nor is overconfidence limited to the trading world. In their book, Decisive (2013), the Heath brothers echo this conclusion, offering a perceptive quote from Daniel Kahneman: “A remarkable aspect of your mental life is that you are rarely stumped” (2011, p. 2). They suggest a number of strategies for overcoming overconfidence biases, including multitracking (entertaining multiple alternatives) and actively considering the opposite sides of our beliefs. The common element among these strategies is cognitive flexibility. Once we are not locked into particular ways of seeing problems – that is, when we are no longer functionally fixed, like the subjects in Dunker's study – we can make better life decisions. We cannot pursue an alternative future unless we first can envision alternatives.

      It is ironic, then, that so many traders – and even trading coaches – insist that we should trade our convictions and increase risk-taking during times of high conviction. Anyone following that advice is likely to take the most risk when they are most overconfident. And all too often that's exactly what happens: Locked into large positions with über-confidence, even flexible traders become inflexible, punctuating winning periods with outsized episodes of drawdown.

      Key Takeaway

      If your risk-taking mirrors your level of conviction, you will always be most vulnerable – and least able to adapt to changing markets – when you are most overconfident.

      Take the case of Joe, a prop firm trader who contacted me following a prolonged period of losing performance. He had been trading stock index futures successfully for several years, but now found that his bread-and-butter trades were not profitable. Specifically, when he left relatively large, resting orders in the book, he found that these were invariably hit, with the market then trading quickly against him. “You can't win,” he lamented in our initial talk. “If you don't get filled, you missed the move. If you get filled, you don't want 'em!” It felt to Joe as if someone secretly knew his positions and was pushing the market just beyond his point of tolerance. Of course, someone did know his positions: Market-making algorithms, continually monitoring and modeling the order book, could rapidly detect supply/demand imbalances and exploit them on very short time frames. A large resting order – in Joe's case many hundreds of ES contracts or more – was a sitting duck for sophisticated market makers.

      A trading coach Joe had previously contacted had suggested that the problem was that Joe was not differentiating his higher conviction trades from his lower ones. If he were to clearly identify the confidence he had in a particular trade and predicate his level of risk-taking on his conviction, he would avoid lower-probability setups and maximize his performance on the higher-probability ones. It sounded good in theory, but worked poorly for two reasons. First, his increased size in his high confidence views led to even greater visibility and vulnerability in the order book. As a result, when I conducted a historical analysis, I found that his hit rate and overall profitability were lower for his identified high confidence ideas than for his more marginal trades. The second problem was that Joe was most confident when he was on a run. As a result, he would make money on one small trade, then another, then another, and then really size his positions only to have them picked off and wipe out his prior gains. At one point, the coach urged Joe to not lose confidence in his judgment: “You have to be in it to win it!” But it was precisely when Joe was in it that he was losing it.

      My analysis showed that when Joe's orders or positions reached a certain percentage of the average one-minute volume trading at that time, the odds of his trades moving against him increased dramatically.

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