Trading is a difficult endeavor, and the main reason most traders fail is that they don’t have an edge. The expectation value of most trading strategies is zero before commissions and slippage. Taking commissions and slippage into account, trading is a negative-sum game.
Even with a positive expectancy trading system, the random nature of the market will likely make traders abandon their good system. Let’s say, for example, you have a good trading system with a winning rate of 60% and an overall positive expectancy. This means that 40% of your trades will be losers. Suppose that you start trading this system, and your first 4 trades turn out to be losers. Human psychological bias will make you conclude that the system is bad, and therefore you stop trading it.
In behavioral finance, this psychological bias is called recency bias. It affects us more often than most of us can imagine. Let’s go through a concrete example of a fictional trader called John.
- Trader John developed or learned about a good trading system, but he stopped trading it after 2 losses in a row.
- Frustrated, he tried a system he learned from a guru on YouTube, and it worked great a couple of times in a row.
- John started believing that he had found the holy grail and started increasing size.
- The market went against him and he experienced a loss.
- John decided to hold on to the loser because his strategy has 90% probability of success, and he thought that the losers would eventually become winners.
- Another unfavorable move in the market created a massive “paper” loss in his account.
- The next day, he received a phone call from his broker asking him to deposit more money to cover the margin. He didn’t have enough money, so the broker liquidated the position and his account was wiped out. John lost almost all of his trading capital.
Does this story sound familiar?
As we can see, recency bias affects our trading in a negative way. The key to profitable trading is to develop a robust, positive expectancy system, have confidence in it, and stick with it, especially through bad times.