Avoiding the Dangers of Overconfidence in Trading
In this article, we approach overconfidence as a trading bias. Now you may think “I should be confident when I am trading, confident in my TA and my strategy” but that can go too far. And it happens to most of us at one point in time.
Overconfidence causes a lot of issues that can blow up your trading account. We need to identify where it comes from, the negative impact on our trading and how to manage it.
Main Reason for Overconfidence
First we need to understand how and when overconfidence starts to kick in. When are we vulnerable to overconfidence?
The simple answer here is after a series of profitable trades. When you have several wins, chemicals like dopamine are getting released, and the brain gets heavily rewarded. We love dopamine and crave more. In particular, men with a high level of testosterone are extra vulnerable to overconfidence. Research shows that people with higher levels of testosterone have less activity in their orbitofrontal cortex. This is the part responsible for our cognitive process of decision-making.
People tend to be overconfident in their reasoning abilities. After a series of winning trades, we act as we know what the outcome will be in our future trades as well, meaning we think less in probabilities and more in certainties. Winning trades work as steroids boosting our confidence, making it easier to cross that red line and become overconfident.
Symptoms of Overconfidence in Trading
One of the indicators of overconfidence is that we increase the size of our trade too much and too quickly. As an overconfident trader, we think we’ve found the holy grail and are not going to be wrong. Then we take more risks than we normally do.
For example, instead of your usual limit of 2% risk per trade, you decide to apply 10% risk per trade. That exposes your portfolio as it makes you vulnerable to overtrading, which is also an indication of overconfidence. In addition, while you normally take 3 trades a week, you decide to take 3 trades a day. You now think that you can “predict” the market. You are trading more often than you normally do. You start thinking about all the money you have already made and you are about to make.
If you have made profits from trading by having a plan and using stop losses then you should think twice before dumping your strategy and overtrading. If you are overconfident, you might find you don’t want to take a loss if things start going against you after a series of winning trades. Since you are convinced you are going to be right, you start ignoring the sensible risk management rules that made you successful.
And make no mistake – it takes just a few trades to completely annihilate your trading account. All because of the overconfidence that led you to forget how you got all these profits. Be very careful not to abandon a successful trading plan due to overconfidence!
How to Combat Overconfidence
We’ve identified the symptoms and effects of overconfidence, but how can we overcome it? The really simple answer here is to stick to your plan. All of us should have a trading plan. Go back to it, and confirm why you used to be successful in your trading.
Forget the idea that you need to trade more often or trade with bigger sizes. Go back to your plan, and if you don’t have one then start preparing one. Trading plans can be short and simple. A typical trading plan includes rules for where you get in, where to place your stop losses, how large to trade and your risk tolerance. If you notice that you are breaking your own rules, then that could be a sign of overconfidence ruling your trades, which seldom ends in your favor.
Don’t be tempted to bend or break or slightly change the rules after a successful run.You must remember that following your plan is what has given you this series of successful trades in the first place, so make sure you don’t deviate from it.
Overconfidence can quickly lead to taking unnecessary losses, but it can be easily avoided. In the end it all boils down to sticking to your plan. If you have a successful trading plan, don’t deviate from it without proper analysis, even if you make many profitable trades in a row.
If you do have the slightest urge to deviate from it, then it would be wise to talk with a coach, mentor or a trading buddy. It is highly recommended to put yourself in an environment where people will help remind you to respect your plan. You can also simply walk away and stop trading for a while. Whatever solution you choose, remember to always be aware of your emotions and never let them make your trading decisions for you.