Should you trade for quick profits?
In this episode of 2Traders Podcast, Walter and Darren examine the psychological concept of hyperbolic discounting, you will see what this is and how important this is to your trading.
Walter talks our natural bias toward seeking opportunities and paying attention to things that support your beliefs. Darren focuses in on the issue of uncertainty and how you can get through this phase. Both traders share key ways to determine whether you should take that trade or not.
Walter also shares how a lawyer has helped him break out of his shell and embrace uncertainty in life — espceially in trading.
Download (Duration: 33:49 / 38.7 MB)
In this episode:
00:52 – clogged pipe
03:09 – willpower
05:19 – write your intelligence
07:50 – certain outcome
09:56 – remove the uncertainty
12:04 – leap of faith
14:16 – embrace uncertainty
16:13 – Shotgun Theory
19:36 – sweet stuff
20:29 – flock together
22:58 – tricking myself
24:34 homeostasis point
26:21 – crappy feeling
29:07 – valid trade
31:09 – missed opportunity
33:02 – be honest
Darren: People strives to remove uncertainty or dampen it or try and remove it as much as possible. I think sometimes that is a mistake. You’re better accept the uncertainty and revel in it …
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: Hi, it’s Walter here. Welcome to the Two Traders Podcast. Darren is on the line. Hello, Darren.
Darren: Good evening, Walter.
Walter: We are going to talk about this concept of hyperbolic discounting, Darren, which sounds like something that your plumber would do for your pipes or something. This is like the third time you had a clogged pipe so you get some hyperbolic discounting or something like that.
It’s weird to me, this idea, but it’s actually really relevant to trading. I thought a lot about it and so, just for the listeners that don’t know, this is fancy schmancy term of saying something along the lines of “a bird in the hand is better than two in a bush.” Which is essentially the old adage that if you’ve got something in hand, take it because you’ll never know what is going to happen in the future.
That is really what hyperbolic discounting is. It’s this idea that we’re more likely to value something that we have right now than to value something that could be worth a lot more but we have to wait a little bit for it.
That obviously comes into play in trading. I think a lot about scalpers. Scalpers, to me, they — I am not a scalper so I really can’t say — but to me, they have this mindset where it’s like, “Look, I’ve got this profit. It’s come to me really quickly. I might as well take it now because I don’t know what’s going to happen in the future.”
That’s probably not fair because there are plenty of scalpers out there that probably also run some sort of trailing exit and let their positions go just in case they really do go and provide a lot of profit.
To me, scalping sums up this idea of hyperbolic discounting and I do believe that it is one of the biggest ones to overcome, particularly for new traders, and I’d love to get your thoughts on this issue as well.
Darren: I want to fire a question back at you first about this. This is basically a bias that we have, built-in to us as human beings. We like the instant gratification even if we know pretty surely that if we waited a bit longer, we’ll actually get a better outcome.
Is this something that is found only in adults or would you find this in children as well? Is this something we’re built with or is it something that we’ve learned?
Walter: That is such a good question and the only thing I can tell you is there’s a classic — and I do mean classic study in Psychology — where they took little kids. These kids are about 4 years old, roughly 3 to 5 I think, and they offered them the opportunity to have — and it wasn’t in the context of hyperbolic discounting but it certainly displayed this.
I think they were talking about will power or something. That is how they couched it. So they put this big, juicy chocolate biscuit in front of the children and say to the poor kid, “You can have this biscuit right now but if you wait five minutes, we’ll give you two”.
So they have this awesome video of these kids sitting there asking how long has it been, what time is it, then finally they broke down and eat them. It’s been redone before. They’ve given them like marshmallows and they do the same thing.
Basically, what they found is most of the kids can’t wait. Maybe they’ve learned it before, they were four years old. You can argue with that but certainly it seems like it’s something that we see from the very young ages so you could argue, obviously, that it’s innate or nearly innate, I suppose.
Darren: That’s interesting that you’re saying it wasn’t in all kids. Some kids could wait.
Walter: That’s fair enough, that’s true but the vast majority of kids couldn’t do it. They just could not wait until the five minutes was up to get the additional marshmallow or the additional chocolate biscuit. It was a very small minority that was able to do that which is an interesting point in itself, isn’t it?
Darren: Yeah. I think with all of these biases that we’ve got, they seemed to show themselves to different degrees in different people. I think with trading that is how we’ve put the problem, isn’t it?
You’ve really got to decide your heat map of what really push your strings and then work that into how you trade. It’s not only knowing that these biases exist in us and they’re likely to sort of lead us down the wrong path.
You need to work out which are the ones for you that really affect you the most as well. Would you agree with that?
Walter: I agree, absolutely 100%. I do think though that you could also argue… Like for example, the classic experiment they do usually in Psychology course is they’ll say write your intelligence.
What should happen is that some people say they’re a little bit below average, some people say they’re a little bit above average, some people think they’re really smart, some people think they’re idiots. It’s a normal curve.
Any random sample of humanity should basically give you a normal curve or what happens invariably is people over-rate themselves, say that they’re all just about everyone thinks they’re a little bit above average and some of them think they’re way above average. No one thinks they’re below average. You know what I mean? This is like an optimism bias.
We think that it can’t happen to us. We think, “Well, maybe some people will have hyperbolic discounting but I don’t.” You know what I mean? Which is another bias in itself. So, you could argue while it’s certainly true that not everyone is prone to hyperbolic discounting, the vast majority of people are. And, if you think to yourself, “Well, that would not happen to me” or “I don’t do that,” that could just simply be another bias that’s seeping in and failing you because it’s not allowing you to consider the fact that you do succumb to hyperbolic discounting.
It’s like this massive circular argument or confirmation bias which, of course, is confirming what you believe by only paying attention that supports what you believe. It’s just crazy hall of mirrors so we can do cognitive biases.
I would say, to me, for traders, it’s a big deal. I think it’s really a big deal and you have to consider it. As traders, we have to assume that we all have this propensity. So the question will be, what can we do to guard against it?
I suppose, if you were a trader and you started out as a trader and you are always drawn to let’s say trailing exits, then maybe it’s not as important to your make-up, the hyperbolic discounting cognitive bias. Maybe it’s not.
If you’re from the get-go where like trailing exits: it does not make-sense-to-me; it’s the only way to go; it’s not really the one and only antidote to hyperbolic discounting but it’s a way of allowing you to stamp that out. That is how I see it anyway.
Darren: I think half of the problem is because of the environment that trading puts you in as well. If you were something like… If you were, say, a savings account and they told you if you kept your money in for another month, you’d get a greater rate. That outcome is certain, that is a certain outcome that you are going to get more.
Whereas in trading, the environment that you’re dealing with is you know that a lot of your trades will go to your perceived greater target but it is not certain. This might be the one that is going to come back and stop you out if you’ll hold it longer.
That uncertainty is adding to this hyperbolic discounting vibe that’s going on and so that adds to it. I think it’s always that uncertainty with trading that highlights these biases to a much greater extent because you know that from your backtesting. That, if you hold your trades longer over a long period of trades, you are likely to do better but it’s always likely, it’s never a certain thing.
I think that really plays in the back of your mind and that uncertainty is what we deal with worse. As humans, we really do not like that scenario.
Walter: Yeah, but that’s what you get paid for as traders by putting money on the line and basically sitting out uncertainty. I mean, that is one way to look at trading. It’s to say traders get paid for putting money on the line in the face of uncertainty, right?
Darren: Exactly and we hate it. We only spend a couple of years studying trading and talking to other traders. You’ll see that, generally, what people strive for is to remove uncertainty, or dampen it, or try and remove it as much as possible.
I think sometimes that is a mistake. You’re better to accept the uncertainty and revel in it a bit. I see a lot of people say this system tested great over ten years but there was one year when a drawdown is a bit high.
I think, “Well, if it tested great over ten years and had one bad year, you really have to look at the ten good years as much as you’re looking at one bad year.” Sometimes, that desire to remove the uncertainty can throw you off from something that might really be good.
Walter: Yeah, absolutely. Looking at just that one, like if that one year was this year and just focusing on that one recent year could throw you off of bad system because you go, “Oh, it doesn’t work anymore” or “The market’s changed now so I am going to scrap it”.
Darren: Yeah. And I think, you’ll struggle to find any trader with longevity that’s made a lot of money and being around a long time, that’s never had a really bad period when things have just gone worst than expectancy.
Walter: Absolutely. And I’ll take it a step farther and say, I think it’s difficult to find a trader who’s gone through that and stuck with his system or her system because those are the ones that like Dunn Capital. Is it Dunn Capital, the one with that four of those brothers?
Walter: So, those guys, they had these down years and yet they keep pushing on. I think for the standard, you’re talking about the standard retail forex trader who’s been doing this for three years, they’ve hooked into a system and it goes really well.
I think in most cases, if they have two down months, maybe three down months with the system, they’ll say, “Look, it’s not working. I’m going to stop trading it. The market have changed” or they’ll change the system, add some rules or something.” I just think that’s really common.
I think it’s uncommon to see people sit through it and just keep plugging away because they’ve got that real confidence that what they’re doing is going to work in the long haul and they’re just in a bad. They’re just in a drawdown, just in a really bad spot this time, this month, this week, this year.
Darren: Sure. And that uncertainty again is playing itself out because you don’t know if this bad period is just a drawdown period to be expected or it means that your system is not working. How do you know? You’ll never going to know 100% with any of these elements. There has to some leap of faith, I suppose. I’m not sure that’s already describe it but you’ve got to be happy with that element of risk.
I think it would be foolish to say that any system guarantees that you will never going to blow up but we all try and work that as a certainty into our system. We are always looking to remove that uncertainty in all of the unpleasant elements. We just want the good stuff.
Walter: Yeah, and I think that’s why traders, typically in the beginning, are drawn to high win rate systems. They are always looking to get a high win rate system. Like, how do I improve my win rate? They are focused on the win rate because they want to be right.
They do not necessarily see it as trying to make money and disregarding the win rate because, in essence, the win rate doesn’t really matter. It really doesn’t. Like, there is a brilliant trading system that take a lot of losing trades. A majority of losing trades by far but people don’t want that.
If you ask anybody who’s offered some sort of forex signals, they’ll tell you the same thing which is this: as soon as they get a winning streak and they have several winning trades in a row, they’ll get more subscribers coming.
As soon as they have a drawdown, a bunch of people would just dump the service like if it’s a monthly fee or something. That is just the way it goes and it shows you this bias that we have which is you want to be right. Like you say, you want to remove uncertainties, it’s part of what people are looking for.
I understand it in the beginning because I was certainly that way too. I am not sitting here saying this is something I had from the get-go because I didn’t. I had the same issues of trying to find systems that had a high win rates but, really, what it comes down to is learning how to lose.
Understanding your numbers of probabilities and managing your risk and then all the while working on yourself and then making sure that you understand that you’re not in control of this. You are not in control of what is going to happen for the next trade. You have no idea. There is nothing you can do and, like you say, you’ve got to embrace that.
I think there was one year… It was about three or four years ago where my New Year’s resolution, Darren, was to embrace the uncertainty. That was literally what I wrote down. Like, “I’m going to live in a moment.” And there was a guy, there was this famous lawyer in the United States. I’ll put him in the shownotes here.
His name is Gerry Spence and he famously never lost a case. He was a Defense Attorney and he had all these clients. He never lost a case and one of the things he said in his book was — he probably has several books but I’ve only read one of them was that — “Part of being alive is having that uncertainty and that fear in life”.
I think the adrenaline junkies are after that, like people who jump off cliff faces in a squirrel suit or whatever. I think that is what they’re after. They’re after this “feel alive” and that’s what trading gives you, that’s what gambling gives you, I suppose. It’s just this feeling of embracing the uncertainty of not knowing what is going to happen next.
Darren: So, this hyperbolic discounting means that we’ve rather take one buck now rather than wait a day and get two bucks. We’ve rather in effect, take quick profits. Are we going down the route here of saying that in trading, that is definitely the wrong way to do it?
And, if it’s uncertain as we say it is, then how do we know for certain that that is the wrong way to do it? How do we know that taking quick profits now, even though a lot of your trades run further, is not the best way to go about it?
Walter: That’s a great question. To me, it’s not that’s a wrong way to do it. Certainly, there are people, they can risk 20 pips and take 5 pip profits all day long and they make money out of it because they’re really good at it. They have a high win rate, they do really well but I think it’s like the Shotgun Theory.
If you’re trying to shoot something in the forest and you have a 22 — I’m not a big gun guy but if you have 22 — rifle which I think has this little tiny bullet, or you have the shotgun that has all these pellets that just spray out of it and you want to shoot something, you’re probably going to be better off with a shotgun in most cases, depending on how close it is or whatever to you when you’re shooting.
It is like that with trading. If you have a really high big, fat winner, it almost allows you to — you’re a little bit sloppy on your execution like you’re not that good, you make some mistakes, if you’ve run into troubles over time but your winners are 3x bigger than your losers — it allows you a little bit of a wiggle room.
Whereas the reverse is not true, right? It is just not true. If you’re risking 20 pips to make 5 pips on your trades, you better be sharp and you better have something that works and gives you an 80% win rate or you’re in big trouble.
To me, that’s how I see it. It’s saying I don’t think that’s the only way to go but I think it’s just, it allows you to be a little bit more sloppy, I guess in your execution which is not saying you shouldn’t execute as best as you can. You know what? I think that’s kind of the thing.
Darren: Yeah, that could be your decision making. The execution of the decision making, as well. You don’t need to be right all the time with your decision making and you still make profit, that is more realistic. Knowing how bad we are at making good decisions consistently.
Are we saying that the probabilities are slightly better for higher risk/reward trading?
Walter: Obviously, you don’t have the winners often so if you have the 50-50, if you’re close to 50-50 or 40-60 or whatever it is or 60-40 then having those higher winners, those bigger winners just allows you to live longer but there is another aspect to this.
It’s interesting with hyperbolic discounting which is, basically, it’s a love diminishing return too. So if I said for example, “Hey Darren, on this next trade, you can make 500 GBP today, or if you wait another 3 days you might make 1500 GBP” versus if I said, “Darren, you’re going to make 500 GBP a day if you close out the trade or if you wait 7 months, you might make 1500 GBP”.
See, what happens is this curve — and I’ll post it in the shownotes too for everyone to see — but there’s this curve that basically says… Because a hyperbolic curve is a one that goes up really quickly and then flattens out and you’ll see it in the shownotes.
Basically, the idea is that if it’s really, really far off in the future, the impact of the additional possible profit or possible reward is dampened. It’s basically, it’s gone. It’s interesting, isn’t it?
Darren: That is probably why we’re drawn to slightly shorter timeframes, as well.
Walter: I would say so. Exactly. That makes sense to me too.
Darren: It does make you wonder how many of these trading decisions we make that’s purely based on the fact that we just want all the sweet stuff and we’re glossing over the actual facts of one’s we’re going on and we’re just saying, “Well, that looks pretty nice to me.” That’s going to feel most trading that and that’s why ended up trading because we do group together, don’t we? And trade the same sort of things, the same sort of instruments, the same timeframes. It’s difficult to find people outside the curve of the norm in trading.
Walter: Yeah, absolutely. I remember hearing about a guy who had all these automated systems and every week, he would choose a few. So he’d have like 2,000, 5,000 systems and every week he would just choose the few that had been performing really well.
I remember thinking, “Wow! That’s interesting. Who does that?” That sort of thing.
There aren’t many traders here doing stuff like that but, you’re right. We tend to sort of flock together and everyone sort of pats each other on the back and says, “Hey! You’re doing the good thing because I am doing something very similar with what you do.”
Walter: You’re not going to grow that way, are you?
Darren: No. We’d talked about this a lot in a podcast about how we are just drawn to what’s comfortable and it’s so often that there’s bad decision to make.
Walter: Yeah, absolutely. It’s almost like a test. Is it something that you’re comfortable with then okay maybe you should be doing it.
Darren: Yeah, or at least question it. You question your belief on it and then look at your facts again as well because I think quite often, we’ve predetermined in our mind that like something uncomfortable, say like 5 to 1 risk/reward, that’s holding most of your trades for a pretty long time.
Most people will find that uncomfortable and will gloss over that . Maybe even if we do back test it, we’ll do it with slightly less confusion and not really check the figures and decides fairly quickly that no, that doesn’t work. Just avoid and finding out what’s really uncomfortable might be the better way to trade.
Walter: Yeah, absolutely. I am thinking about this, like in terms of the way that you trade because so much emphasis is on the exit and exiting the trade. Is this something that you think about? Like in terms of, “Am I taking profit too early?” Or, do you know what I mean? How is this come into your thinking?
Darren: I nearly always take profit too early. I’d say 1 in a 100, I hold for that a bit longer but I’ve progressively got better and better and so it’s less of a defining element of my trading.
When I first started out trading, I always take profit way too early and now I’m taking it a little bit early than I should be. I’ve just gotten better as time has gone on. Also, what I’ve done, I’ve stretched my target beyond where it needs to be.
Let’s say, I really want 3 to 1 risk/reward, I’ve set in my target 4 to 1 so I’m not quite getting to my 4 to 1 target but I still get over to my 3 to 1 target. I’m tricking myself, basically. I know it’s a lie but I’m just playing along with the bias and I am saying, “Okay, this is what my brain is going to try and do to me. I am going to trick it.”
It’s like where people set an alarm every five minutes and I’m just trying to work with that bias rather than some saying I need to eradicate it completely. The other thing I’ve done is the way I trade now, I looked at my stats the other day. I’m in a trade 94% of the time so that feeling of being in a trade and the outcome being significant is gone now because I am always in a trade.
I’m always in a few trades so I think I’ve subconsciously worked that in to deal with that emotion as well because I’m always in a trade now,. It doesn’t feel as important, the getting out of a trade, and that’s never really like a completion for me. It’s just like a rolling, continual trade.
Walter: Wow, that’s fascinating. It’s almost like desensitization. Like if someone would’ve take, like my friend, Dennis, he takes about one, maybe two trades a month and if you would compare him to someone like you, where you’ve taken so many trades.
You’re almost literally always in the market, it would seem like it wouldn’t be as stressful. It would not affect your decision making, I suppose, as much because you’re always at that homeostasis point which is “I’m in a trade.” You know what I mean?
Darren: Yeah, sure. The same with the entry as well because my entries, essentially, come at the close of every bar. It’s not like I am making a significant decision. It’s like bars close, I’ll set my entry, I’d go back about my business.
I am not saying that is a brilliant way to trade but it’s a system modeled around getting the best for me and avoiding the worst of me. I found things I like and slowly modeled them so I don’t make the same stupid mistakes that I usually make. I don’t know whether that’s a good way to go about it either. It’s just what I’ve done.
Walter: Yeah. I think it’s saying your results are going well so it seems to be working and it’s not like you don’t lose sleep over it. You don’t feel like you are doing the wrong thing. You feel like you’ve hit it even though you know that you’re probably not go all the way to the 4 to 1 target. You’re tricking yourself.
I think a lot of traders do a similar thing with performance goals. Like if they say, “Look, I want to make x percentage, I want to make 5% this month.” They might really be okay if they make 3% or something like that.
It’s like a goal. If they’ve hit it, maybe they’ll stopped trading or something like that because they’re scared they’re going to give back and then they’ll reset next month, start all over, but they’re okay thinking, “Look if I make 3% a month, that’s 36% a year and I’m okay with that.” That sort of thing.
Darren: The thing you do need to watch out for though is you’re always going to have that crappy feeling afterwards that you took profit. That’s always going to be there even if you’re making a sufficient amount to make regular profit.
I did it just last night. I closed out some trades, they were at my target. There was nothing wrong at closing them there but price continue to fall all night and I felt really bad about it. Still, I achieved really what I needed to achieve from the trades but I still have that bad feelings.
You need to be aware of that and you also need to be aware of acting out that feeling because I do remember in the past, I do that and I say, “Oh, I’ll jump back in here.” And then, you’ll end up in right mess because now you’ve just freelancing and throwing money around. So, you do need to be aware that you’re going to feel bad even if you hit your target, you’re always going to have that feeling.
Walter: Yeah, that’s right. It’s true. The only thing that I can say to that and still doesn’t — I mean, it can help in some ways if you spread your bets on all of them — so, you’ll say, “I’ve got a target, I’ve got an aggressive target, I’ve got an easy target, I’ve got a trailing exit.” Those sorts of things.
You start to split up your positions but in that case, you’re still going to say, “Look, it’s great that I had this little tiny positions that I left on the trailing exit but wouldn’t it be great if I had all of the trailing exit, right?” I mean, that is the other side of that. Even though when you do that, you’ll still going to feel like, “Ahh! I should’ve put it all on the trailing exit”.
Darren: You’re always going to find something to regret.
Walter: Yeah, exactly. Can I ask you something? Just setting aside because it’s related to this tangentially, which is two situations. You have a situation where like this, like we’re talking about. You have a trade, you took the trade then you got out of trade and you’ve made a profit but then it kept going like exponentially past the amount.
You made a 100 pips winner, you’ve put another 100 pips for example. So, okay, that’s situation one. Then, situation two is the trade that you saw but you didn’t take it for whatever reason and then later on you see that it went as far as your target or whatever.
Which one of those, situation one or situation two, would be more difficult for you to deal with?
Darren: For me it’s not taking the trade because when you’re in a trade and you’ve got profit on the table, you’ve got real facts to base a decision on there. You’ve taken a trade, it’s gone your way. You’ve got a choice whether to take the profit or not. You’ve got real data to work on there.
When a valid trade sets up and you leave it then you’re really — if it’s a valid trade — then really you’re just basing your decision on a feeling and a feeling of fear, or anxiety or uncertainty and those mistakes are much easier to avoid.
I think if you want to be, if you want to make a living from trading, you need to learn to avoid making the easy mistakes, if nothing else.
Walter: Right. It’s not taking the trade when it’s there?
Darren: Yeah. I mean if it’s a valid trade, if you’ve got real data to say that you should leave this trade, then it isn’t really a valid trade in my eyes but I still do it. I did a couple the other week. I left two trades purely because I was a bit uncomfortable with the current situation on my trades. I left two valid trades and they both went straight to TP and that hurts a lot more.
Walter: Yeah, I agree. I’m on the same way because I think you can talk yourself out of the one where it went another 300%. Well, I’ve got something out of it, right?
Darren: That’s going to happen, you know.
Walter: Yeah, exactly. But, the one that you saw and then for whatever reason,you didn’t take and then you come back and you go, “Oh my!” My theory on this is that we’re wired as traders to seek opportunity and that’s the core of what draws us to trading.
Seeking out these opportunities and I think that is why it hurts so bad because it’s an opportunity that we had and we just let it slip through our fingers. That is just so painful.
I agree. I think situation two is the one that I really don’t like.
Darren: Is that like hyperbolic discounting there? Because you’re looking at avoiding an opportunity where it’s a valid setup and a potential you know. You should know the probabilities of that going to profit but you’d rather just take the missed opportunity than that possibility of a loser.
Darren: Is that the same thing?
Walter: I guess it would be because you are defending your account. You’re saying, “I’d rather keep the money I’ve got in my hand than put it at risk for this additional trade”. To me, it seems weird.
I do it, I have done it. I did it about 5 weeks ago. I did one. It really killed me too because when I woke up in the morning, I saw it. I told myself, “Oh! I forgot to place it” or whatever. I passed out or I got stuck eating ice cream last night and I forgot about taking my trades because I do my trading at night.
Sometimes, I am just doing other things, watching Youtube videos. I was like when I woke up and I saw that one, it just killed me and I do think it is such a difficult thing to get over as a trader because my theory is that’s what we do. We look for opportunity.
Darren: I find that when I do my recap videos of the week and I go back through the week, I find that these trades where I made a decision mistake based on fear or whatever. When I am upfront and honest about that in the videos, I find that as a cleansing thing and I find it over time that it reduces the amount of those mistakes I’ve made.
So, in a way sort of coming out and sort of verbally express it, “Look, this is what happened here. It was a valid trade” rather than coming up with some sort of crappy excuse; “…because of all this news, it was coming out” or whatever. If I’m upfront and say, “Look, this is valid trade. I didn’t take it because I was scared.” That kind of expressing that emotion means that next time, I don’t get it strong.
Walter: I agree. But, the key here is you have to be honest, like you say, and you also have to be open to — I think it’s useful if there’s like a two-way interaction — you have to be open to people questioning you. You know what I mean?
Darren: Yeah, sure.
Walter: That helps too because if they would, “Why would you do that? Why was it a valid trade?” or “Why did you do that? Why did you do this? I don’t understand this?” I think that’s helpful because it makes you reconsider your approach.
Okay, cool. This has been really a good episode, Darren. I thank you for your time and I will see you next time.
Darren: Cool, Walter. I’ll see you soon.