In life, being optimistic is an important trait that every person should have… but not in trading. In this episode of 2Traders Podcast, Walter and Darren dig into the topic about Optimism Bias and how this can be dangerous to a trader. Walter stresses out how important it is to consider certain factors first and anticipate what you want to happen with your trade rather than just make drastic decisions based on how the market is doing at the present.
Also, Darren shares some useful tips on how to avoid the optimism bias and how a simple note can save you.
Download (Duration: 25:08 / 28.7 MB)
In this episode:
01:02 – what draws people to trading?
02:36 – black swan events
04:26 – it needs a structure
06:00 – acceptable behavior
08:26 – take the punches
10:07 – really tiny account
11:31 – what the successful people do?
12:22 – how we start to trade doesn’t help
14:16 – a combination of things
17:25 – always tweaking it
19:48 – other elements
20:56 – core idea
22:12 – key to success
23:34 – make some notes
You have to learn to be wrong and you have to learn to let go. [Click To Tweet].
Do I really have to take this trade?[Click To Tweet].
A strategy doesn’t necessarily have to have an edge, just a structure. [Click To Tweet].
Walter: The real danger of optimism bias is it takes our eyes out of the ball. To me, trading is really all about risk management. If you don’t understand that, it will just be an expensive lesson.
Announcer: Two traders, Darren and Walter, pull back the curtain on profitable trading systems, consistent money management, and profitable psychological triggers. Welcome to the Two Traders Podcast.
Walter: Welcome back to the Two Traders Podcast. Walter here and I’ve got Darren over there.
Darren: Hi, Walter.
Walter: Well, Darren, we’re going to talk today about this idea of the optimism bias. This is something that, to me, applies to traders. Obviously, as traders, one of the reasons why we get into this is because we focus a whole lot on what can happen. What you want to happen.
You want to make this pile of money. You want to have some freedom. Usually, those are what draws people to trading. You can get paid for taking risk instead of getting paid for offering your hours to a company or a boss or somebody. Even as a consultant, you’re really offering your time, in most cases.
In this case, you get paid by taking risks. That’s really what trading boils down to. A lot of traders are pretty optimistic. This can get a lot of traders in trouble because, as we know, the optimism bias — I will just to define it for everyone here — it’s when we believe that we’re less likely to experience a negative event compared to other people.
For example, if you’re out playing golf and it’s a thunderstorm, there’s lightning all around you, you think “oh, that lightning is not going to get me”. Or as a trader, you see things like the Francogeddon and September 11th, surprise intertrade announcement, assassinations, all these things that affect currency pairs and you just think “well, that’s not going to happen to me. I’ll never be in a trade where that happens and my account gets obliterated because the market moves so fast. A stop loss won’t even save me then.” That sort of things.
My thoughts are, basically, that most traders are not designed or we don’t focus on the negative as much. As a rule, we tend to focus on the positive. We tend to focus on how much money can we make with this system.
We don’t focus on the drawdown. We tend to focus on what’s possible in forex. We forget about these black swan events that can literally wipe out our trading account. We focus on the broker that gives us a lot of leverage and that sort of thing.
Maybe we don’t focus as much on the brokers that we should be feeling comfortable with because they’re very liquid. They’ve got a lot of deposits. They’ve got a good track record. They’ve got systems in place so that if Francogeddon happens they don’t go belly up like we saw what happen with a four letter broker that I won’t mention, the very famous one.
Basically, they went belly up and if they didn’t have their loan sharks coming they would have been gone. They were saved by a big wad of money ‘cause they were basically a liquid after that.
That’s kind of my thinking on this but I want to get your thoughts on the optimism bias: “that can’t happen to me” sort of idea. How does that applies to trading?
Darren: This is an interesting one. I see a lot with people’s notion that somehow their approach or strategy has given them something that all other traders haven’t got. A lot of people buy into that belief really, really easily that somehow their strategy is not going to suffer like all other strategies do.
Even if they detour and test it and you say to them, like you say “they can have drawdowns in that”. I think they’ll still approach trading that “well, it did happen in the past but I’m not really expecting it to happen again.” Somehow, their knowledge and their skill has just given them that extra edge.
That’s a really dangerous mindset to get into. I really train myself on this belief that your strategy doesn’t necessarily have to have an edge or such. It needs a structure. You’re still relying on the market and what the market does next. It’s really important to keep that at the forefront of your mind.
You’re not really able to remove those elements just by a strategy or if you are, say, likely to work long time. I think people have a difficulty with that because they have this over inflated optimism about their particular strategy. Often, they’re doing the same as everyone else.
You read about other people having difficulty and having a hard time in losing money but somehow, their little take on it has given them something that nobody else has got. That’s how I see it manifest itself with traders.
Walter: That’s a great point. You see a lot of these where everyone else is using RSI — and I’m using the RSI and Bollinger Bands or whatever it is — and other people aren’t aware of this. My uncle works at Bank of America and he’ll tell me when the EUR is going to go down or whatever, this sort of thing.
I mean, it’s tough for me to believe that as a trader. Think of all of the participants in the market. Think of even those that have huge advantages, like banks. The banks know when their clients are going to put in huge orders and and they can put their orders in front of their client’s orders. That’s acceptable behavior. That’s a way of making money for the banks.
You can’t do that as a retail trader but, you have advantages. You’re more nimble. You have access to greater leverage. You’re not a hedge fund where you’re trading at two to one or three to one leverage. Most of the traders out there listening to this are probably at least trading fifty to one leverage.
Leverage can work for you and against you. The focus on what’s possible and start projecting “oh! I made three percent last week. I’ll make twelve percent this month, and I’m going to make a hundred and forty percent in a year or whatever when compounded.” Those sort of things, we can get caught up in that.
To me, the real danger with optimism bias is it takes our eye off the ball and to me trading is really all about risk management. If you don’t understand that — you will — it will just be an expensive lesson. That’s just the way I see it. I don’t see how you can call this anything other than “that’s a game of risk.”
Too often, we take our eye off the ball. We focus on what’s possible, on that pines in the sky sort of thing, which is just fine. It’s good to be motivated by that but it’s like, you hope for the best but plan for the worst. I don’t know if that’s something that fits with your approach, Darren, but I really believe in anticipating what you want to happen with your trade.
Just planning for what may not happen and so you’re okay if everything falls apart and you get stop out. Or even, you can go as farther from your stop and slips you a bit but you don’t want that to happen. You want to focus on that.
When you’re calculating everything, when you jump into your trade, that’s what you plan for. When I take a trade, my thought is these losses. Is that going to kill me? Is that going to ruin my month? Usually, the answer is no. And then I’ll say “ Is this the trade I really have to take?” Usually, the answer is yes.
That’s how I approach it. As a trader, what do you do to try and avoid optimism bias?
Darren: I’ve definitely been through that. It was difficult. I did trade with a mindset that I was never going to lose even though I knew that I took losses all the time. I think, a lot of it is finding that comfort spot for you and stay in there for a long time.
It’s almost like you have to take the punches. When you’ve been through enough punches then you get to the end of line and you think “okay, there is no avoiding this”. You start then, perhaps, looking at yourself. It seems become quite apparent where you’ve been going wrong then.
When you’ve done all of that, chasing different systems and tweaking your system and trying to find the answer that way, you just get to the point where it’s almost like someone taps you on your shoulders and says “you know what’s going on here. You’ve been basically denying it all this time. You really need to change your mindset about how you’re trading.”
It’s very difficult and a lot of people come to trading and they’ve been successful in other fields, not necessarily just find out market-related stuff whatever they’ve been successful in. People naturally feel that they should also cheese that success quickly in trading and I think that’s probably why a lot of people blow up, or they eventually quit on trading.
It’s difficult. It’s a time thing. It takes a lot of time. You can get a lot of blows. I think you’re probably at an advantage if you’ve come to trading with very little money because you can’t throw a lot of money on it, initially. You have to build up your trading account so you can’t go too horribly wrong because we all do come to it with that optimism.
Walter: You bring up a good point which is — number one is: I always recommend that you start trading with a really tiny account. Sure, you want to trade live. Sure, you want to see the system works. Sure, you want to see how things are going to pan out but certainly you don’t use all of your risk money in the beginning. Get comfortable with the smaller account.
The other point that you bring up which is really interesting to me is this idea of success and how, if you think about it, a lot of traders who have been successful in some field — maybe they were a doctor or business person and they’ve got this money — that they want to use it towards trading, and that their next step in life is they want to learn how to trade.
I’ve got a friend who’s very successful and he keeps dropping hints that he wants to learn how to trade — I actually think it’s a bad idea. The reason why — and I’ve told him this — is that you have found a lot of success in business and you’ve done quite well, now you want to trade.
Well, trading is really about being wrong and trading is about not holding on to your beliefs. That’s a little bit different to what happens in a lot of business scenarios where if you believe strongly in something, you do really well. If you’re absolutely convinced that something is going to work, you keep powering through it and through all those barriers until you get to the point where you are doing well.
I don’t think that that translates well to trading where we know we’re going to be wrong and we know that we have to let go when we’re wrong. That’s not necessarily what the successful business people do.
You don’t see a lot of people like if you look at all the success stories, for example, what you’ll typically find is that this business person who finds success with their company. It may have been their seventh company or the seventh idea, or the inventor who finds success with his invention or her invention. That may have been the twelfth invention that they came up with.
That’s the kind of thing where they just keep pushing on, keep trying, keep trying, keep cracking at it. With trading, you have to learn to be wrong and you have to learn to let go. If you can’t do those things and you’re always moving your stop because the trade is going to eventually turn around — keep adding to a losing position because you know you’re on the right side of the market — that, to me, is a red flag. It’s something you have to either unlearn or just decide “okay, this isn’t for me”.
Darren: How we start to trade doesn’t help as well. Most of us start trading, start at home, on our own, with no guidance, with nobody there to say — to basically go over what you did the day — and can say “look, that’s where you made a bad decision there. This is what you should have done. What was going on there when you’ve made that decision?”
Most of us don’t have that. If any of my friends come to me and ask me about trading, I’m seriously pessimistic. I’ll say “you know, I really don’t encourage any of my friends to get into it.”
That’s not because I don’t think that they could make it as a trader but because I know how much it has taken over my life and perhaps, they’ve already got pretty decent jobs and families and very settled in their lives.
I think, even if I do want to introduce, it does take over your life for a lot of people. I don’t think you can really do it as a part-time thing. I pretty much spent twenty four hours a day for the last eight or nine years just thinking and working on trading.
Whereas, I do other things as well. I was quite lucky I was single, I didn’t have a lot of obligations outside of what I wanted to do myself. I’m quite pessimistic now for people coming into it because I hate introducing something and it go horribly wrong.
Walter: Why do you think you’ve found your groove? What is it about it? Is it that you just kept added and that you didn’t have other distraction that normal people have like a job, or you’ve got a job sixty hours a week or you’ve got two kids and you’ve got to take them to soccer that’s sort of thing? Why is it that you’ve been able… is it just because you have enough time to focus on it?
Darren: I think it’s a combination of things. For me, personally, one: because I’ve had enough time, not have other obligations so I could really devote myself to it. Two: because I didn’t have a lot of money.
Even though I’ve experienced a lot of losing, I wasn’t losing certain amount of money that’s a bit psychological issue for me. If I lost a couple of months wages on trading, it’s not the end of the world for me.
I suppose the key thing was, strategy-wise, was when I stopped following the rules and say “hang on a minute”. When I look at the chart, this is what I see. All the rules say otherwise but, what if I’ll just trade what I see instead of listening to this other people?
Who are they anyway? Why should I believe them and not believe what I’m seeing on the charts? So, sort of combination of things, really.
Walter: That makes sense. Part of it too, at least for me, was finding something that would fit with my personality. Trading the five minute chart is definitely not my sweet spot. I knew that I need to spend as little time watching the chart as possible and that was going to help me. I tend to make better decisions when I would see the charts after not seeing them for a while.
Whereas, if I sat and saw the charts unfold and print before my eyes, that really mess me up. I don’t know if that’s the case. I suppose some people are quite happy to sit down and bang out trades for four, five hours on the five-minute charts and then they’ll close their computer and they’re flat for the day and all that.
But, some people just can’t hold on to a trade for weeks and weeks on it and it drives them crazy. Usually, it means they’re trading too large a lot size but, whatever.
Some of it too is… some people listening to this are going to say “I have no optimism bias. I’ve never been able to turn a profit”, or something like that, which is sad. In other words, they’re saying “this doesn’t apply to me.”
What I’m saying is “we’ll find out what applies to you. Find out what your groove is. Find out what you believe.” Do you believe that when the market goes really far, it’s bound to snap back? Well, that tells you something about how you should trade.
Do you believe that it’s possible to trade the daily charts and have an average hold of seven days on your trades and make money that way? Or, do you believe that you have to trade the one-hour chart?
Those are the things that direct you into the spot that you needed to be. If you’re stuck right now, if you’re listening to this and you’re stuck, there’s a couple of things that could be going on here.
One, you might just be trying to trade someone else’s system. Doesn’t fit you.
Two, you just might have your risks all wrong.
Or, three, you might not really have confidence in what you’re doing. You’re always tweaking it and you’re never really trading the same thing. We can probably talk about that in another episode.
I guess, the point I’m making is — the whole point of this episode is — as traders, we often overestimate the good stuff. We think that better things are going to happen to us than others. We’re less likely to hit that big nasty drawdown.
There’s a lot of biases operating there; hindsight bias, and optimism bias, and lots of those biases that can creep in. What do we do about that? It’s important for you to make sure that this is what you really want to do and find the system. Find an approach to the markets that really makes sense to you so you don’t leave it, so that you keep with it.
For example, how long have you’ve been trading the system that you’ve been trading? On the one-hour chart, Darren, how long have you been trading that?
Darren: I’ve been trading that for three or four years and so it’s evolved, obviously. It’s evolving.
Walter: It’s evolved. Right
Darren: But the core principle is exactly the same.
Walter: In other words, this isn’t one of those things that you’ve been trading the last three months or something like that. It’s not something that you picked up on forexgurumillionaires.com or whatever.
It’s something that you’ve taken, and you’ve molded it, and you’ve work with that and something that makes sense to you. Which the core is, basically, the markets move. When the markets move, I want to make money. When the markets don’t move, well, then it’s going to be a little bit tough. That’s basically it, right?
Darren: Yeah. You have to do that to really make it successful. A group of traders that have been following my system and he’s interested. Out of all the ones who’ve been successful with it, none of them are doing it the way I do it.
One of them is using it to scalp. He’s using the entry and he’s using his old scalping techniques for the exit. Another one is trading it on the daily and he’s kind of change the entry. He’s trading lots of pairs, like fifteen or sixteen pairs, and just taking really small profits on the daily.
Of all the ones who are doing really well, they’ve change it and they’ve put in those other elements. You’ve really hit the nail there. If you read Market Wizard and things like that, all of those guys, they’ve all kind of it’s not like – “okay, that’s a textbook, trend trading pull back sort of strategy.” Even if it is, they’ve just added their little thing to it.
Where they thought “you know what, this is really what I believe in and I’m gonna go. I’m gonna run with that.” I really think that there’s key.
Walter: Absolutely, and I’ve seen the same thing with the traders that have taken my way. The way that I’d look in my engulfing set up which is, it’s a special case of engulfing. Some of them say, “Hey, Walter, I disregard support and resistance. I don’t even care about it and I’m just going to trade every single signal that I see and I’m always on the market.”
Other traders say “Hey, Walter, I’m only going to trade this with the trend”. Other traders say “Hey, Walter, I’m going to use this with the moving average and help identify pull backs.”
There’s multitude of ways that you can do it but, I think you’re right. The key here is if you have a core idea that resonates with you and you start to adjust it and tweak it out and make it really, really comfortable.
It’s kind of like that car. You get that car and it’s new. You like the car but it doesn’t really feel like your car until you’ve got your music in it or you’ve got your fuzzy dice hanging from the mirror or whatever it is, that you’ve got your coffee in there, whatever it is that you break it in and it feels like your car.
That’s the same thing with trading. Where we all need to get to that point where what we’re trading is our system. It doesn’t really matter if I learned it from Darren or Walter, or I’ve read it in some book, or on a form, or something like that. Doesn’t really matter.
What matters is it’s at the point where it’s like, “I know this system, it really makes sense to me. It’s going pull profit from the market when I precisely define when it’s going to be successful because that’s how I want to trade the market since I want to do that.”
Whether it is “I want to trade pullbacks”, “I want to trade trends”, “I want to trade revergent to the mean”, “I want to trade breakouts”, “I want to trade swing points”. Whatever it is, it doesn’t matter. It’s you, and I think that’s really the key to success.
To me, in some, I guess about optimism bias which is how this whole thing started is it’s easy to see something in trading especially when it is someone else’s and go “wow, that’s amazing. I’ll just do that” and “that looks really good” or “I’ll just add this thing”. “I’ll just add little sugar to it, that’s going to be magical.”
I think it’s a little bit more involved than that. I don’t think that you can just pull something out of the box and do really well with it and I think you need to stress-test it, too. You need to consider: what’s the worst drawdown I would’ve seen with this? What if I double or triple that and would I still be able to trade it?
What if I missed the best trade of the year? Will I still be able to live this system? What if I’m on a holiday in Cambodia and I missed the signal of the year, would that really change my bottom line on the annual return?
All these things have to be considered and instead of just thinking “I can’t wait till year seven one. I’m a multimillionaire, I want to hit the ten million mark”
These are the things we have to think about but shifting the focus to slightly can do a whole world some good. That’s basically my advice on the optimism bias.
Darren: Like what I’ve said many times before, make some notes because it is amazing how quickly when just one or two trades are going bad before you even hit the stop loss. It’s amazing how quickly people get knocked by that and start questioning what they’re doing and get thrown off by it.
You see people start the day full of optimism and if the first trade goes badly, they get really knocked by that. Just some simple notes of what to expect.
For instance, I have at least two losing days every week and if that’s not ingrained in me, and if I didn’t completely expect it — I wasn’t used to it — then that would throw me. I’ve seen it in myself.
For traders, two losing days, the third day they’ll stop and question what the market is doing. Questioning it whether it is because of this news, and they should have a day off. Questioning their exit strategy. Where just two days before, they were a hundred percent confident that this was it that, you know, they have perfect strategy and nothing needed changing. So, just some simple notes to deal with these biases ‘cause it really throws us.
Walter: That’s excellent advice. Thanks for your time, Darren. We’ll see you in the next episode.
Darren: Okay, Walter. Cheerio!