When you have an equity upswing, or a series of winning trades, don’t you feel -even if a little bit- on top of the world? I used to not only do that, but also start projecting future revenue and trading profits based on that event. Like if I made $1000 today, I can make 15-20K from trading per month since there are 20 trading days. Which would translate into at least $180K per year… Trading is easy, life is good!
What happens next is I would start to lose focus and discipline, take excessive risks and increase my position size. Then I would wake up and come back to reality as soon as a couple of losses hit my account again.
Similar to draw-downs, winning streaks are an inevitable event in trading. You are definitely going to run into them while trading the markets. That is assuming that you follow every signal produced by your method with discipline and persistence. While your account balance will thank you for these winning streaks, they can harm your conditioning and throw you you off guard if you are not paying attention to your conditioning.
How It Happens
I believe that the overconfidence that naturally comes from an equity run-up can be linked to the “Recency Effect”. Wikipedia defines the Recency Effect as:
A cognitive bias that results from disproportionate salience of recent stimuli or observations. People tend to recall items that were at the end of a list rather than items that were in the middle of a list.
To put it simply, other things being equal, we tend to give more weight (and validation) to things that have happened closer to the present moment than things that have happened in the past. For traders, they start to generalize the case of winning (something Charlie Sheen is known for). Losing money start to seem like a unlikely event, the trader start to increase position size trying to make more money in less time. However, just when the trader is least prepared, the winning streak comes to its inevitable end.
A great evidence of how overconfidence causes investors to take larger positions is the presence of large trading volume around market tops. It demonstrates overconfidence caused by the Recency Effect for the trading crowd.
Staying Calm, Cool and Collected
- Condition yourself in a way that makes following your trading method with discipline extremely pleasurable (regardless of whether you make a profit or a loss). Once you’ve achieved that, you’ll start looking at equity upswings as nothing but a byproduct of following your trading rules.
- Similarly, trying to outsmart your method is very painful (regardless of whether it temporarily makes money or not, breaking your rules is painful). This helps your mind gravitate towards sticking to your trading rules to avoid the threat of pain of long-term loss and giving back profits made.
- Having a predefined money management plan is key. Your trading plan should include a detailed description of your money management technique, when do you add unit/lots to your position size? When do you decrease size? It helps to have a sheet of account balance levels and how many units to trade at each level in advance. Some traders say you should cut down your position size after winning streaks, I respectfully disagree. Consider this: how do you know a winning streak is over? First loss that follows it? What if the next trade was a winner? Personally, in trading I like to move away from techniques that rely on hunches and intuition. I like to use clear-cut rules and methods because there’s enough chaos in the markets to mess with your hunches and turn them upside down.
- Think in terms of performance as opposed to money. Performance in trading is all about discipline. Check to see if you followed your trading rules at the end of the trading day/month/year. If you were disciplined, your performance was good. If the money doesn’t back that claim up yet, rest assured it will do over the long-term.