Fear and Overconfidence

May 6, 2021

Mark Douglas #2 

Remember that trading is short-term. And with proper risk management, it is possible to lose several trades in a row, and eventually have a profitable investment that will cover the losses of the previous trades, and make you additional profits on top of that. That is possible if you practice proper risk management and only trade when you have a good reward risk ratio. How to do that is a topic for later. 

The point is, when you take on several losses in a row, whether it is in trading or investing, it is likely that you sooner or later you will experience some form of fear, anxiety or distrust in the strategy you are using (if you have one at all). It might take a few more losing trades to get there, but at one point you will ask yourself what happened.  

This blog is the second part from Mark Douglas book “Trading in the Zone” 

To compensate for the losses of the previous trades, you might want to take a larger risk on the next opportunity or you might start to do more thorough analysis of the market conditions and sentiment in your effort to better estimate the next opportunity. 

On the other hand, at some point in time you might become overconfident once you win one trade after the other. It might be after a few successes or it might take some more successful trades in a row, but eventually you do become overconfident based on your successes so far.  

The overconfidence can cause you to accept increased risk on your next opportunity. You might increase your order size. You might increase the risk by allowing bigger market price movements before you stop your losses. You do this because you seem to be confident in the direction the market is going next. After all, you were right so far. Why would the market not behave the same again?  

It is simple human nature to become overconfident if the successes stack up one after the other for some time. Mark Douglas teaches us how to conquer our natural tendencies and how to develop a winning attitude. 

Firstly, he explains the two types of analysis you can do. There is the fundamental analysis versus a technical approach to the market. Mark has his own view on the role of these analyses 

Fundamental analysis, according to Mark, can help, but the prediction about where prices should be at some point in the future could be correct, while in the meantime, price movement could be so volatile that it would be very difficult, if not impossible, to stay in the trade in order to realize your objective.  

On the other hand, as a method for projecting future price movement, technical analysis has turned out to be very powerful as compared to a purely fundamental approach. It keeps the trader focused on what the market is doing now in relation to what it has done in the past, instead of focusing on what the market should be doing based solely on what is logical and reasonable. Technical analysis is mainly looking at charts, using different tools and techniques to understand what is going on in the market now, and predict what is going to happen. 

According to Mark, fundamental analysis creates what he calls a “reality gap” between “what should be” and “what is”. The reality gap makes it extremely difficult to make anything but very long-term predictions that can be difficult to exploit.  

The technical approach opens up many more possibilities because it identifies how the same repeatable behaviour patterns occur time frame after time frame. Technical analysis turns the market into an endless stream of opportunities to enrich oneself, and it closes the reality gap. 

Please be aware that Mark is focusing on trading in this book. Technical analysis is very important for short-term trading. At the same time, the points he is making regarding psychology, mindset and being in the zone, is applicable to any kind of action and strategy you use in the financial market, whether it is short-term trading, or long-term investing.

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