Optimism Bias: It can seriously affect your judgment and trading performance.

Optimism Bias: Is a natural human bias that causes a person to believe that they are less at risk of experiencing a negative event compared to others, or that they are more likely to succeed or be good at something than reality would suggest.

Firstly let me stress, ‘Optimism is good’, most successful traders I work with, as a coach, are typically optimistic, they believe they can beat the market and often do. However they are also self-aware and have a high degree of humbleness (Which tends to run contra to the popular image presented in modern day culture). As an ex-professional trader, I actually think we need a degree of optimism to switch on the screens and start trading every day. We need optimism to return to the fray after the market has given us a severe beating, and we need optimism to balance the natural fears we have which can cause us to panic out of certain trades or which lead to other poor decisions.

However, over-optimism, as emphasized by the optimism bias, can be extremely damaging: It forces people to take trades the should they never should engage in, warping their view of reality, and damaging their objectivity. All of which culminates in a state of ‘unrealistic optimism’! This matters, it matters a lot! As a consequence, people’s decision-making and judgment become heavily impaired, causing them to over-estimate the possibility of favourable outcomes, and under-estimate the likelihood that trades will fail. Ultimately their risk-reward is going to be skewed, perhaps quite heavily. Whether you are an investor or trader, and whether your approach is fundamentalist, technical or quant, whichever method is your poison, you need to have an edge, and that edge is the mathematical outcome of your risk/reward ratio.

This excellent and entertaining TED talk by Tali Sharot talks about the ‘Optimism Bias’ will illuminate you further on the ‘Over-optimism’ bias. 

What can you do to help you over-come the effects of ‘Optimism Bias’ in your trading? Firstly, I would say that you are unlikely to alter your actual ‘optimism bias’, it may vary in certain people and situations, but all people have it. Rather like your shadow, it will always be there, it is a part of you that evolution has welded into your psyche, and that acts in way to impact your perceptions and decisions just below the level of consciousness.

Nonetheless, there are certain ways you can behave or act to try and counter its effects.

1) Raising Awareness is a first step. Hopefully articles such as these are part of raising your awareness of ‘Optimism Bias’, though no doubt within a few days, if not hours of reading this, your memory and conscious awareness of ‘Optimism Bias’ is likely to fade. However a seed will hopefully have been planted that can be nourished through further reading of the human behavioural aspects of decision-making and other memory-stirring practices.

2) Creating a more structured way of trade selection, trade management, and risk-management should help combat optimism-bias. A more structured approach does not have to be too rigid and heavily rule based, by doing so I believe can harm your adaptability and creativity. However by developing certain rules or guidelines and trying to adhere to them, you should create a stronger discipline and allow yourself to create more control over the sub-conscious forces which can derail your trading.

3) Use a Trade Journal or Diary (Either written or electronic). This has many benefits, including:

• ­Supporting a more structured approach as discussed above.
• ­Allowing one to plan their trades more effectively, therefore creating greater objectivity.
• ­Reminding the person of the initial reason and rationale for the trade, and therefore helping to remain on track.
• ­But in this context, I like a trade journal as a ‘Behavioural Awareness’ tool: Let me explain: If you record many of your trading decisions you can then periodically look-back and review your decisions and actions. We rarely learn from our mistakes, because we tend to shut our minds to them. This is part of ‘Optimism Bias’, we don’t want to recall our stupidity or poor-trading as it damages our self-belief, therefore we often banish them from our memory thus allowing us to foster the ‘self-belief’ which is necessary for trading success. Unfortunately, the downside of this is that it also feeds one’s ‘Optimism Bias’. However, by recording reasons for our decisions, and the actions that followed, even just with a few words, (I prefer keeping journals simple: ‘Less is More’), then we can return to them in the future. By reviewing our journals through time, we can raise our awareness of our actions. I use to do this during my trading days and shocked myself when I realised some of the behavioural patterns and mistakes I was repeating. ‘If we are not aware of them, we can’t even start to address them’.

4) There are many other actions we can take to fight the ‘Optimism Bias’, such as seeking alternative opinions, looking at trades from alternative perspectives, active use of Stops/Trailing Stops etc. This is all part of the toolbox one develops during their trading experiences.

On the other hand, you have to ensure that you don’t extinguish your self-belief, it is important to remain optimistic in the face of the many challenges and hurdles that trading throws up. But one should always strive for greater realism and objectivity whilst trying to balance all these various divergent and opposing forces and finding a way which provides a clear edge to one’s trading.

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The 'Behavioural Trading' blog is written and managed by leading Trading Performance and Behavioural Trading Coach Steven Goldstein. Steven is Managing Director at Alpha R Cubed, who work with banks, hedge funds and investment firms to help them improve their people's capabilities within their frontline financial risk businesses. To know more about Alpha R Cubed, visit the website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven directly on Twitter.

GBPUSD FX trade idea, set-up and some trading psychology.

Occasionally I like to look at and write about what I view as favourable trade set-ups. This year, I have only documented a few, however most of them have had a good record, even if timing was not quite right. My favourite calls this year have been long USDJPY at the start of the year, though on the trade I had on, I took profit too early, though I wasn't complaining about an 8 big figure gain. I also have been long USDJPY since late October and remain so, with a 'in the money' trailing stop guarding it. Another trade which worked well for me earlier this year was long EURNOK, though I don't think I documented it in this blog, it was mentioned in this article here (See performance coach, championing it as a trade). I also dabbled in AUDUSD, calling the bear early in the year, and the recovery a little later, though my timing was slightly out, and I traded it far worse than I analyzed it, which has always been my challenge as a trader. Overall I'm glad to say that my trading account, which is merely a hobby for me these days, is significantly onside,though some ugly attempts to get in and out markets at times, usually in EURUSD have helped erode gains somewhat.

Now I think I may have found another trade I like. - Long GBPUSD spot (or Cable as us FX types call it.)

First let me sum-up my usual formula for identifying what I consider as potential good value trades: I don’t tend to base my view from fundamentals, though I like to consider fundamentals in the equation when I feel I have a good view of them. My preference however is to look at a set-up technically, if I like it I then look at the risk reward, is it favourable relative to where a stop would be and to account for the volatility of the market?  If it has what I consider a decent fundamental case to back it up, then even better.

Currently the long GBPUSD for me largely fits this set-up, I am not altogether sure of the fundamental case, after all both the UK and US currently have recoveries, if only modest ones. Like most trades, I am sure if I need to then I could fit a good supporting fundamental argument later, if it goes the right way!!!

Technically there are a few things I like about this trade:

1) The 'Failure' of the multi-year 'Bear Triangle' to follow-through on a downward breakout and the subsequent reversal: I love failures, people rarely look at them, they prefer to look the other way for completions and continuations, but failures can be great trading set-ups, and few are better than Triangle failures. The fact that it has broken through the top side of the triangle line, now adds to this. Potentially failures can have very sharp and relatively quick reversals which can move far further than people often consider. The long-term weekly chart below shows this clearly.



2) A Weekly 'Bull-Flag' formed over recent months: The breakup of the Bull-Flag has coincided on the move above the top line of the large triangle. This projects, using traditional technical analysis measures, potentially to around 1.7600ish and change.

3) An shorter-term (Using the 4 hourly chart) 'Bull-Flag', formed over the past couple of weeks.

One final thing, which is interesting; note the similarity of the above two charts, this year's weekly chart, and the lower 4-hour chart. Its almost like there is a fractal relationship, where the lower chart is repeating the set-up of the above chart. It could be merely be co-incidental, I may be looking for patterns within patterns, where none really exists, however I have seen similar market price action in the past, which have as I recall occurred prior to large moves. (Psychological point: I may be accessing selective memory and recalling a situation to fit a desired outcome, that is one reason I use protective stops.)

Psychological perspective: As this blog is principally about the psychology of risk and trading, and as a trading coach working to help enhance trader performance, I thought I'd add some psychological perspectives: In this case I would like to talk about some of the major 'Cognitive Biases' which affect traders, and how this could impact my performance on this trade.

- Loss Aversion:  We are all prone to Loss Aversion; Loss Aversion is a feature of who we are, not a flaw in our make-up, as some people seem to think. Loss aversion is basically our innate need to avoid losses rather than seek gains, as such it biases our behaviours in certain ways. The most common affect seen in trading is to run losses, so as to avoid crystalising them, but to quickly grab at gains, thus locking them in. Hence we make small gains and suffer large losses. This behaviour can be highly destructive to managing a trading book or portfolio, in my own trading I try and put trades on with a favourable risk reward profile so as to help counteract this bias, and always use a stop to protect my self from running losses.

In the above trade I have placed the stop a little below last week's 1.6290 low, adding some room to avoid getting hit by stop hunters. I have a target around 1.7000, this means currently my risk reward on this trade is potentially 3.5 to 1. A very favourable return. I have also entered a risk amount equivalent to about 2% of my trading capital, thus I am unlikely to have highly elevated emotions driving my behaviour. We are more likely to fall victim to basic destructive default behaviours, such as loss aversion, when we are more emotionally charged: Having too much at risk, relative to capital can cause this. On the other hand if I am right, on this trade (And remember there are no guarantees) then I could return about 7% of my capital.

- Over-confidence/Over-optimism:  This might seem slightly odd, here I am talking about our natural aversion to losses, which seems a little 'Cup Half-Eempty' and yet at the same time we are bias to believe in rosy outcomes, i.e. 'Cup half-full'. Research after research shows that we are mostly over-confident in our belief in our own abilities, and over-optimistic that the future will be bright. This is not necessarily a bad thing, one needs a high degree of confidence and self-belief to be successful and to keep coming back when so often beaten up, as markets can do. However, the ying to this yang, (or is it yang to the ying!) is that many traders immediately discount a favourable outcome to their trade, and possess over-confidence in their ability to forecast the market. As a consequence they may take a larger risk than maybe prudent.

I am no less vulnerable than the next person when it comes to over-confidence and over optimism, as I said above, these are features of who we are rather than flaws in our character. However, it is good to be aware of these, and to understand how they can damage your performance. - In order to help overcome or offset this bias, having a structure to how you take risk is important. With regard to my trades, I carefully set my trade size relative to capital, this ensures that I do not over-expose myself, in addition I also size my trade relative to how much I am willing to lose, not to how much I expect to make. Note, I am a firm believer in adding to the trade if it moves in my favour, if that happens in this trade, I will look for favourable risk-reward areas to add value, using gains I make along the way add leverage.

- Confirmation Bias: This is another significant and potentially damaging cognitive bias which we are all vulnerable to; it is something I have been particularly susceptible to in the past. (These biases don't go away just because you know about them). Confirmation bias is where we try to prove our point, or back up a belief we have by seeking confirming evidence. The danger with this; people close their eyes and ears to potentially conflicting evidence, sometimes digging their heels in and becoming stubborn in their beliefs. One step to helping offset this is to investigate one's intuitions and analyses a little more deeply, taking a more objective perspective, and perhaps even trying to disprove one's views. Sometimes trying to disprove a view can make it more robust. Of course this is not foolproof, we are all 'blind to our own blindnessess', and as mentioned above, prone to over-optimism.

In the above trade, I started by a taking a quick look at the 4-hour chart, I liked what I saw. Then I felt I needed to look at the longer term charts in order to see how it looks there. I first took a slightly longer view, the weekly chart, then looked at the much longer charts. In both cases I actually felt more convinced the trade was right. This was a simple trade, and that description, I admit is pretty simple, but that kind of sums it up.

- Finally my philosophy: 'I could be wrong, and if I am , then so be it'. Trading requires losing in order to win. Accept that you could be wrong, it helps!