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.


Sunday, December 03, 2017

Three Key Ingredients of Trading Success

In a recent post, Mike Bellafiore explained why one of the traders at his firm has been experiencing career-best success lately.  What Mike modestly leaves out from his post is that quite a few of the traders on that floor have been experiencing their best ever returns.  That creates a wonderful database for studying the ingredients of trading success.

The first contributor to success is simply the market environment.  It is not a coincidence that November was a stellar month for the active day traders.  Many smaller cap stocks in the blockchain/crypto space have made huge moves intraday and over the course of a week.  It is very difficult for directional traders to achieve stellar returns in low volatility environments, something we're noticing among hedge fund returns lately.  What enables the active traders to achieve solid returns is their ability to direct their trading to what is "in play" at the time, thereby finding spheres of opportunity when VIX is still modest.  The principle here is that what you trade is as important as how you trade.  You can be the greatest gold miner in the world but go broke if you're digging in the wrong places.

On a parenthetical note, I might mention that the above principle is as important for longer time frame participants, not just the active day traders.  The directional macro investor typically benefits, not simply from volatility, but from trend.  If you look at the returns of hedge fund traders this past year, you'll find that the ones doing well have tended to be those who have been long stocks (or a combination of long stocks and long bonds in the risk parity trade); short volatility (which has trended lower most the year); and/or trading "mean reversion"/relative value strategies (in which stretched relative relationships tend to retrace in lower volatility environments).  Like any entrepreneur, the successful trader has to operate in a market that provides distinctive opportunity.

The second contributor to success for the traders who have had career best months and years has been the presence of an overarching visionary goal.  Several explicitly stated to me early in the year that they wanted to be million dollar earners this year.  It was a regular part of their thinking, and it framed how they thought about their performance.  The presence of a vision kept them energized and provided the motivational thrust for working on their trading.  Holding the vision kept them excited and energized through the year.  In many cases, that excitement and energy carried over to members of their team, fueling their performance.

The third success element for these traders was having small goals to accompany their large visionary goal.  The small goals were the things they needed to work on day to day and week to week to keep getting better.  Without the large, visionary goal, the smaller, process goals would have been mere drudgery.  But without those short-term process goals, the big vision would never have come to fruition.  As Bella explains in his post, it was the accumulation of trading improvements during the year that set the trader up for exploiting the trading environment.

When you have an inspiring vision and a robust process for working toward that vision each day, you set yourself up for success when opportunity arises.  

How are you preparing for success in 2018?


Saturday, December 02, 2017

Trading Psychology Challenges - 7: Overtrading

Sound trading lies at the intersection of rigorous thought and decisive action.  Without rigorous thought, we trade randomness and fall prey to impulse.  Without decisive action, we betray our best ideas.

Overtrading occurs when we take risk without a clear edge in our trade.  On the surface, this seems like madness.  Why would a rational human being risk their hard-earned capital on an idea without merit?  The answer is that even rational human beings can fall short of consistent rationality.  Under conditions of fear, greed, frustration, and overconfidence, we can act mindlessly--in ways we would never contemplate if we were in our normal, grounded state.

Peak performance requires full focusAny distraction impairs efforts that require concentration and pattern recognition.  Watch weightlifters before they snatch their weights; golfers before their putts; kickers before their field goal attempts; basketball players before taking a free throw:  all will compose themselves, get themselves in the right state of mind, and then perform.  Great performers summon focus at will.  They have stronger focus muscles, and they have superior control over those focus muscles.

Suppose a surgeon finds himself distracted immediately prior to a surgery.  Would he or she blindly go forward and make an incision?  Of course not.  The surgeon would first find their focus, make sure the team has made the necessary preparations, carefully review the surgical plan, and only then move forward.  Above all else, do no harm is the commitment of every physician.  Life is precious.

Every trade is an incision in your net worth.  The capital you're trading is precious.  When we find ourselves distracted or emotionally aroused during the trading day, we need to do what the surgeon, weightlifter, or golfer would do:  slow ourselves down and engage in a routine that reinstates focus.  Slowed and deepened breathing, accompanied by a review and/or visualization of what we want to be doing, can be very helpful in grounding ourselves.

I'm a big fan of keeping two lists at one's side during trading.  One is a to-do list that captures everything you look at and everything you do when you're trading at your best.  The other is a to-don't list, which captures all the wrong things you engage in when you trade poorly.  With those lists in front of you, it's easy to conduct a focused review before placing the trade to ensure that you're aligned with your best practices and not repeating your worst ones.

In recent posts, I've addressed steps we can take when our trading is impacted by performance pressures; anger or frustration; and negative, perfectionistic thinking.  All of these can lead us to act on impulse and overtrade.  I'm currently working with several traders who are having unusually successful years.  They have demonstrated an improved ability to catch themselves in the wrong states during the trading day and refocus their efforts.  Improved self-awareness has enabled them to work on their mindstates in real time.

Equally important, however, is to avoid overtrading that results from boredom.  Many times traders find themselves staring at screens even during times when they know they shouldn't be trading.  Sure enough, they notice something that looks meaningful and act upon it, without clearly thinking through a bigger picture and plan.  In such situations, it is not enough to simply count upon "discipline" to avoid the overtrading.  What is needed are positive, alternate activities that will move your trading forward, even when you're not trading.

Those alternate activities could include rejuvenating oneself through exercise, social interaction, or meditation.  They also could include getting away from the desk to work on research and generating the next set of ideas.  Many traders I work with identify--in advance and in their calendars--the hours in which they want to be trading and hours in which they want to be doing other things.  There is no time for boredom--every hour is moving you forward in some fashion.

The cure for overtrading is self-mastery.  When your head is in the game, you work on the game.  When your head is elsewhere, you work on your head.  Approaching trading the way surgeons approach their craft is a great way to avoid doing harm

Further Reading: