As we have mentioned in a previous post, there are three main pillars which are the basis to a profitable trading account. These three pillars are strategy or “move” as it sometimes referred to, risk management, also known as “manage”, and finally “mindset”, which takes into account trading psychology.
There are many different types of traders, who are characterized by particular traits. Each different type of trader will have their own strengths and weaknesses. One of these trader types is the over confident trader. Now if you are new to trading this may seem a million miles away, but some personality types can find themselves here relatively quickly.
In 2006 James Montier carried out a study on fund managers behavior. The study was published “Behaving Badly”. In the study James Montier questioned over 300 fund managers about their perceived performance across the year. 74% of fund managers believed that they had performed above average, whilst 100% believed that they had performed average or above average. The fascinating point being that only 50% could ever have performed above average!
Whilst confidence in trading is certainly a very useful trait, overconfidence can be very dangerous. Overconfidence is an exaggerated belief in your ability to succeed. If you have had a good streak of winning trades where one after the other has gone in your favor time and time again, you may start to think that you’ve cracked it and that you really are a trading genius.
The overconfident trader will typically believe that they rarely lose a trade, this over confidence tends to then lead to trading decisions which are sub optimal. For example, the over confident trader is much more likely to over trade. The overconfident trade is much more likely to place significantly more trades than someone who has much less confidence in their trading. The overconfident trader is also much more likely to trade beyond the parameters set out in the trading plan, which could prove to be a fast way of blowing the account up.
How to Avoid Becoming an Overconfident Trader
There are a couple of steps that can be taken to avoid falling into the over confident trader trap. You must keep your focus on risk rather than the reward, so effectively turning yourself into a risk manager rather than a trader. Keep asking yourself, where is the risk in this trade? Could the trade be hit by some economic data due to be released? Are geopolitical tensions about to flare up? Are central banks about to meet?
You are able to manage the risk so it is essential that you look out for things that could go wrong. This is even more important when you have had win after win after win. It is often stated that a trader is at their most dangerous after a solid winning streak. If things are working out great, stick with what’s working but also make sure that you are trading within your set parameters and that you ask yourself where is the risk? What could go wrong?