This will be the first of a series of articles I plan on writing about cognitive biases and how they affect trading.
What is a cognitive bias?
A quick and simple definition is a cognitive bias is an error in thinking that affects the decisions and judgments that people make.
There are many different cognitive biases that exist, I’ll be going over one called ‘Outcome bias‘ in this article.
Outcome bias is basically judging a decision by its outcome rather than how the decision is made or the thought process behind it.
So how does this tie into trading?
I’ll start by putting this out there: Just because a trade made money doesn’t mean it was good, and on the flip side just because a trade lost money doesn’t mean it was bad.
This is an argument I’ve gotten into with a few newer traders as well as some more experienced ones who tend to stand by a belief that a trade should always be judge by its results (whether it made or lost money), I am firmly on the side that a trade should be judged on the thought process and decisions made behind it rather than the outcome. It’s one of the most frustrating things to me when this argument comes up, but so many people stick to the belief that if a trade made money then it is a good trade and if it lost money then it’s a bad trade! I don’t believe this at all and let me try to explain why.
Take roulette for example, if you place a $100 bet on lucky number 17 and it comes up 12 and you lose, is it a bad bet? Yes, no??? What if you make that same bet, $100 on lucky number 17 and 17 hits! You just made $3500!! It must be a good bet then right??
The answer is….
It doesn’t matter if your number hits or not! It’s a bad bet both times! But ‘how??‘ you might ask, ‘I just profited $3500, obviously it was a good bet!’. This is the outcome bias in full effect, you are judging your decision to bet on roulette based on the outcome that you had, not on whether it is a good bet or bad bet. The reality is it doesn’t matter whether you win or lose, the casino has an edge on you and you will lose in the long run. Whether it’s a good or bad bet should be determined before the outcome is known!
So how does this tie into day trading? Well, you can look it at the same way as the roulette example. Lets say you have a ‘gap and go’ type of strategy where in addition to a few other filters you long any stock gaping up more than 4% at the open, and sell in ten minutes or the first pullback. Through back testing and trading experience you’ve determined this strategy is profitable 60% of the time and has a W:L ratio of 2:1 (see my Basic Trading Math post for more info on this). Clearly this is a profitable and winning strategy that you implement, but like every trading strategy it will have a mix of winners and losers. If you trade this and the numbers hold true you will have lost on approximately 40 trades out of 100. Does this mean whenever you have losing trade on this ‘gap and go’ system it was a bad trade? No! of course not! It’s a trade that has positive expected value, whether it wins or lose that one time doesn’t matter because it will be profitable in the long run, that’s what’s important! It’s the same on the other side, if for some reason you don’t like money and are trading a strategy that loses 9 out of 10 trades and wins small when it does, the one time it’s a winner doesn’t make that a good trade, it is part of a losing system destined to cost you money!
Now that the proper way of thinking is understood the next question is how do you know whether or not your strategy has a positive expected value or not? This is a little more difficult to answer since trading can be so dynamic but the best way to do this TRACK EVERYTHING. Excel is one of the most powerful tools a trader can have, I noticed a huge difference in my personal trading results when I became proficient with excel and started tracking all of my trade data. There are countless different ways you can implement tracking, the best way to start out is separating your trades into different strategies and put those in different columns. For example, have one column for ‘break outs’, another for ‘breakdowns’, ‘gap and go’, ‘fading’, ‘opening momentum’ etc. Under each column add in your profit or loss for each trade, what time you entered, the price, how many shares you took, the float, was there news, etc. The information and benefit you get from this is eye-opening. There will be no more guess-work, no more ‘I think‘ you will know exactly where you are making money and where you are losing, what trades have a positive expected value and which ones don’t. You may find you make money playing break outs long but lose on shorting break downs, so quit trading break downs and focus on break outs! You could find you are only profitable on low-priced stocks, or you suck at trading the close but you make money trading the open. Whatever the results may be you will be able to stop judging individual trades based their unique outcomes and know whether or not they are profitable in the long run. Thinking of the long run and avoiding outcome bias is essential to being profitable as a trader, it will also make casino table games a lot less exciting as well!