NEGATIVE EFFECTS OF OPTIMISM IN TRADING
The biggest one is a propensity to ignore risks.
One of the reasons why beginners fail—apart from their lack of technical knowledge, of course—is that little bit of natural optimism that most of us have.
A newbie usually opens a trade account with too much money in his pocket because he does not contemplate the possibility of failure.
As a consequence, he starts immediately risking more money than he can afford to lose.
An experienced trader, however, is already making money. He does not usually have a plan b in case his strategy stops working for some external reason because he has not yet learned to be pessimistic.
Financial markets change over time. No strategy is eternal. Every time the market shifts, changing its nature, a lot of traders burn their accounts. This is because, after many years of success, they have not realized that they too could become obsolete.
Traders tend to do not innovate. Once they have a good strategy, they stick with it until they lose too much money or someone else stops them.
Everyone ignores execution problems
What almost everyone ignores is the type of event that is so bad or rare that it “cannot really happen”.
Very few people are aware of the possibility that their broker might have servers down—or that, for some reason, they cannot access the trading platform.
In that case, having a second broker, or opening a position opposite to the one running with the inaccessible broker, would be necessary. Usually, however, no one has a “back-up” broker in place.
Brokers, like anyone else, can go bankrupt. This happens especially in the CFD world, which is why I only trade regulated derivatives using brokers licensed in G7 countries. Everyone believes that it’s only someone else’s broker who can go bankrupt.
If there is a stupid way to lose thousands of dollars, it is because the internet connection is down at a crucial moment or a laptop is broken. This happened to me years ago, at the beginning of my career. I could not close a contract on an ES future. It was in profit… closed in stop.
Everyone, including institutions, ignore fat-tail events.
What if you are long in a stock with a stop loss of 1%, but when the market opens, it gaps down 80%, and you are forced to take a huge, unexpected loss?
What if you sold a contract on live cattle futures, and every day , one hour after the open, it closes in limit up for several days in a row, without executing your stop loss orders?
What if the options you sold on natural gas very out of the money and with a one-year expiration suddenly become in the money?
The events I have described above are real. They have happened to more than one person I know over the last two years. Each time, it was the first time that something so bad had happened to that person.
There is no way to forecast these events. Otherwise, they wouldn’t be fat-tail events, but at the same time, it is very easy to not burn your account when they happen.
Low leverage is usually enough. In fact, I have rarely seen accounts with zero leverage go to zero.
If you have 50 different stocks and no leverage, if one of them goes bankrupt, you’ll still survive.
The same is true for a portfolio of trading systems on futures contracts. If the account is big enough, even pretty bad events will be painful, but not enough to kill your career.
It is possible to get more sophisticated using options to cover part of the risk, but low leverage is still a necessary condition.
Even if these events are very rare, if you are trading for many years, they will almost surely happen to you. This is the reason why I have never in my life seen a single trader survive using high leverage and being unaware of them.
The right trader mindset
A trader should be slightly pessimistic.
Being very pessimistic is, of course, wrong. It will cause you to not trade at all.
A very well-known institutional trader here in London, who was one of my clients years ago and who trades thousands of contracts on commodities, is mostly concerned with how his orders get routed.
He works for an institution where there is a whole team helping him and taking care of the whole trading process.
Although his salary is extremely high and he has been extremely successful, the last time I met him for breakfast, he talked about new ideas for how to hedge his positions in case he could not close them without having a market impact. He is only interested in how to overcome new problems that he has not encountered yet.
Beginners who trade $1000 USD accounts have a toxic optimism. Although optimism helps us to proceed in everyday life, it leads new traders to fantasize about what they could buy with their trading profit—a fantasy that causes them to completely ignore risks of any kind.
On the opposite side, superstar traders tend to be more realistic—even pessimistic—and spend their time worrying about how to be protected against bad events. They do this, for example, by spending another 10 million on developing executions algos or getting better data.
Once again, in finance, in order to succeed, it is necessary to implement very counter-intuitive solutions.
Everyone would think that a trader like my ex-client, who manages billions in derivatives, must believe so much in himself. Why else would he think about how to conquer the world or what yacht to buy next?
In reality, one of the reasons why he is a winner is that, thanks to a pessimistic mindset, he never ignores risk. Other traders, however, do.
Once someone thinks that he already knows enough, he stops learning. And because the market keeps changing, at a certain point, he will become obsolete and have no money left to trade.
Every time I have met a trader who has been successful thanks to his deep knowledge of the market, like quantitative traders, I have noticed that they are very humble and still willing to learn more.
I am talking about people with a PhD in math and several papers published, as well as a history of good, positive returns.
When I met E. Chan, for example, although his knowledge is beyond human possibility, he was so curious about what the other people were saying that he took notes when something was interesting to him.
Everything that boosts a trader’s ego will cost him money sooner or later.
Every time a beginner has a positive year, he will double his trading size. This is because his self-esteem has increased and, consequently, so has his lack of awareness about risks.
One of the reasons why the path to being a trader is so steep is because most of the steps that lead to success take us in the opposite direction of our human nature.
We all want to feel safe, and we achieve this by believing that bad things only happen to other people. We believe that we are better than we really are to make ourselves feel secure.
Someone with a “positive mindset” is more accepted among other people, while a more realistic or pessimistic mindset is often considered less friendly. In fact, we all are encouraged every day to be more optimistic.
If, among other traders, you are the one who is always being told that you are worrying too much, you must be doing something right!
Warning: There is a risk of loss in trading. It is the nature of commodity and securities trading that where there is the opportunity for profit, there is also the risk of loss. Commodity trading involves a certain degree of risk, and may not be suitable for all investors. Derivative transactions, including futures and forex, are complex and carry the risk of substantial losses. Past performance is not necessarily indicative of future results. Please read additional risk matters on our web site www.londontradinginstitute.com
It is important you understand all the risks involved with trading, and you should only trade with risk capital. This communication is intended for the sole use of the intended recipient and is for informational purposes only. It is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument.