When it comes to generating consistent profits through day trading, traders armed with a deep understanding of technical analysis and economics have an edge over their less informed counterparts.
However, this technical knowledge isn't worth much if you haven't mastered your own mind.
Let me explain.
Often, humans make unconscious errors in their thinking when they're processing and interpreting information – they're called cognitive biases.
These errors may impact the accuracy of our analysis and decisions and the worst part is that most people don't even realize they're making an error.
Day trading requires processing a lot of information, therefore, it's easy to make thinking errors that can cost you a lot of money.
These errors can be avoided by developing and implementing a trading plan; however, it also helps to understand how our minds can lead us astray.
To do this, we must be able to identify and understand some of the common cognitive biases. By learning to identify when and how you're falling victim to cognitive biases, you can take steps to change your thinking and behavior.
In this post, I'll discuss three key cognitive biases that might be negatively impacting your trading.
1. Seeing patterns that aren't there AKA the clustering illusion
Day trading involves analyzing a lot of patterns.
Unfortunately, that creates the perfect conditions for traders to succumb to the clustering bias or clustering illusion.
The clustering illusion refers to the natural human tendancy to see patterns where none actually exist.
The reason we may see patterns where none exist is because the human brain naturally seeks to impose order on the world. That's why you see shapes and faces when you stare up at the clouds on a sunny day.
Consider an example:
Perhaps you notice a pattern in a chart that seems to regularly precede a major price move up.
Your brain learns to recognize that pattern and you start to see it more frequently.
The next time you see the pattern you decide to throw your risk management strategy out of the window and take a long position, betting 30% of your account.
Unfortunately, the market moves against you and you're left wondering what happened.
The pattern and relationship you thought existed, never did – you created the illusion in your own mind.
This bias is a common cause of superstitions and mistaken beliefs and just being aware of it will make you less susceptible to its perils.
2. Trying to recoup your money AKA the sunk cost fallacy
Even experienced traders fall victim to the sunk cost fallacy, which is defined as:
The general tendancy for people to continue an endeavor, or continue consuming or pursuing an option, if they've invested time or money or some resource in it.
For example, suppose you take a long position and the market runs up.
However, remarkably, the market quickly tanks, and your profits evaporate.
Your losses rapidly accumulate and your healthy account balance is gone.
Instead of cutting your losses, you hold your position for several days, hoping for bullish sentiment to return.
Unfortunately, it doesn't.
Traders and investors alike think to themselves:
I've lost so much I can't exit my position now.
However, this is irrational.
What counts is an asset's future performance and if there's no sign of a turnaround in the future (e.g., fundamental evidence the stock looks good), traders should cut their losses and move on to the next trade.
Sticking with a plan when it no longer serves you is a recipe for disaster when trading.
Rational decision-making requires you to forget about the costs incurred on a trade, no matter what you invested. Indeed, only your assessment of the future benefits counts.
Being able to maneuver in the face of new information is an art, a powerful weapon that can save you time and money.
3. Overestimating your abilities AKA the overconfidence effect
Successful day trading requires a lot of hard work and many traders are driven and goal-oriented.
People with drive often display "type-A" personality traits including confidence and competitiveness. And while these traits can help a trader succeed in and outside of the markets, they can also contribute to big losses.
Over-confident traders are more likely to open many trading positions, take positions that are too large, and believe they are smarter than the market – all of which make for unsuccessful trading outcomes.
Some of the signs you're overconfident include:
Research indicates that if you're overtrading, you're likely overconfident.
While overtrading can be defined differently for every trader, the guidance suggests that if you're exceeding the number of daily trades defined in your strategy, you're overtrading. For example, you normally take 5 trades a week, but you decide to take 5 trades a day.
This article offers guidance about how often to trade.
2. Volatile swings in your profit and losses
Volatile swings in your P&Ls are likely occurring because you're taking more risks.
For example, you may have had a series of wins and decide to step outside of your trading plan. This can lead to big wins, but also big losses.
A key sign you're falling victim to overconfidence is taking on more risk relative to what you normally do.
Combat overconfidence by sticking to your trading plan and following your rules.
3. You're attributing losses to bad luck
When day traders lose money, they often attribute it to bad luck and downplay the role their skills (or lack thereof) had in the outcome.
Overconfidence like this is dangerous and makes you more likely to jump into a trade without doing enough research or stay in a trade for too long when you don’t want to admit to yourself you were wrong.
However, what underlies these excuses is the belief that you're correct and you experienced bad luck. You may think to yourself "soon the market will reward my strategy."
However, your losses are presenting evidence and you should focus on understanding the mistakes you're making and potentially adjusting your trading strategy.
In sum, many trading experts agree that successful day trading has more to do with understanding your own mind and its unique susceptibility to fall victim to various mental traps than it does with knowing every indicator or chart pattern.
By understanding common cognitive biases that traders fall victim to, you'll be better prepared to capitalize on opportunities and recognize looming risks before it's too late.