A Balancing Act

Seasoned traders, trading coaches, and behavioral economists warn traders to reign in their overconfidence. As a young trader who managed his own account put it, "I realize that if I have a big winning period that I shouldn't get overly excited because, most likely, I'll have a flat or losing period just around the corner. That's the way the market works. No style of trading makes money all the time. The odds are that after you have a big winning period, you'll go through a period of losing money shortly thereafter. I try to make enough money to give myself a cushion to handle the losses when they come." A seasoned trader said, "If you're overconfident, you fall into traps. When I have a string of ten days where I made money every day, I have to watch myself. I have to get more defensive after a string of good trading days because I am tempted to think that I'm invincible. In that mindset, I take bigger risks." A successful hedge fund manager said, "During winning periods, it is easy to become overconfident, and that can lead to trouble. While overconfident, I feel a false sense of security. I'm tempted to take unnecessary risks, and I start to think that I don't have to do any more research to find and figure out new ways to extract money from markets. It is easy to fall into a sense of complacency." What's the solution? One trader I interviewed suggested humility: "Every time I have issues with confidence, I become overconfident. I try to be very humble when I trade. You're only as good as your last trade. It doesn't matter what you did last month,last year, or the last ten years, it's what are you doing today."

A winning trader is confident. It's essential to have the proper amount of confidence, however. If you are under-confident, you'll have trouble making money as market conditions change, but if you are overconfident, you may over-extend your trading knowledge and assume that you have skills that you don't actually have. Building genuine, rock solid confidence in one's trading abilities takes time. It's necessary to experience a variety of market conditions and learn which trading
strategies work best under which specific conditions. It's not something that happens in just a few months, and some trading experts say it takes several years of trading before one moves from the status of a newbie to that of a seasoned trader. In the meantime, novice traders walk a tightrope between under- and overconfidence: sometimes they feel they don't have enough confidence while at other times they may have too much. It's often hard to find the right balance when first starting out, but it's an issue to cope with until consistent profitability is achieved.

Although overconfidence can lead to risky trades that may produce losses occasionally, a lack of confidence can be even more detrimental. It's probably not a good idea to be optimistic to the point of putting on trades without carefully managing risk, such as limiting the size of a position or using protective stops, but a moderate amount of optimism and confidence is useful. A study by Dr. James Felton and colleagues in the "Journal of Behavioral Finance," sheds light on this initial finding between overconfidence and trading performance. University students taking a finance class participated in a 13-week simulation. Each participant was given an imaginary $500,000 to invest. There were some real incentives for doing well in the simulation, however. Students could win $500 if ranked in the upper quartile of the simulation, and a portion of their grade was based on their performance. Optimism was measured with a reliable and valid psychological measure. "Risky" investments were defined as investing in futures and options and as the number of transactions made across the 13 weeks. Men and women did not differ in their levels of optimism, but optimistic men made more risky trades (futures, options, number of transactions) than pessimistic men, pessimistic women, or optimistic women. Optimism can be a good thing. Pessimists often panic, become fearful, and tenaciously deny they are in a losing trade. A moderate amount of optimism keeps a trader calm and inquisitive. Even in the midst of a losing trade, an optimist may be more likely to seek out information and make an informed decision.

Finding the proper level of confidence is key. It is a little like walking a tightrope between extreme unrealistic optimism and extreme debilitating pessimism. Finding the right balance will allow you to pick yourself up when you are beaten down, but stay grounded in reality even after a huge win.

Just as a young child must venture out into the unknown, a novice trader eventually must explore new trading strategies and trade under more chaotic market conditions. It's at these times where a typical novice trader becomes overconfident. He or she may cope with feelings of vulnerability by building up a false sense of confidence. Perhaps it is out of inexperience or a need to bolster one's wavering confidence, but the novice trader may feel an unjustified sense of omnipotence when facing uncertain and potentially threatening market conditions. Telling yourself that you are powerful and infallible can help you feel that you can conquer the most difficult challenge, in the short run, that is. In the long run, it can spell disaster. One may trade low probability setups without a clearly defined plan or adequate riskcontrols. Building a strong sense of trading skills is a key for
achieving consistent profitability. It's how you go about it that ismost critical, however; one can do it in a reckless, haphazard approach or build up skills with a well-planned controlled approach. Keep in mind that when trading under new market conditions and with new trading strategies, you are taking greater chances, and it's at these times when you need to carefully manage your risk and steadfastly follow your trading plan. By taking such precautions, you will minimize potential harm and be able to master new domains. The piece of mind you gain through a well-defined trading plan and adequate risk controls will allow you to tackle new challenges with enthusiasm and vigor. Over time you'll master new strategies and gain a strong, intuitive sense of new market conditions. With increased practice, you'll achieve long-term profitability. So don't fall off the tightrope without a safety net. Trade with the proper amount of confidence, and if you do need to take risks, acknowledge the tendency for overconfidence and take precautions to prevent it from interfering with your goals of achieving lasting profitability.

The winning trader is both confident and realistic. If you want to trade like a winner, it's vital that you develop a true sense of self-confidence. By gaining a wealth of experience, your confidence will be based on your actual trading skills. When you know what you can do and what you can't, you'll feel calm and self-assured. You'll know what you can handle, and you will be able to trade with solid,realistic confidence.

source: forex roundtable