Trading Wisely: Overcoming Cognitive Biases in the Options Market
The Biases in Our Stars and Trades
Ever wondered why traders make decisions that seem perfect in the moment but turn out to be costly blunders later? Welcome to the fascinating world of cognitive biases in trading. These potent mental shortcuts often override logic and strategy, stealthily, subconciously influencing decisions from analysis to trade execution. Let’s explore some of the common biases that often shape our trading decisions and eventually impact our P&L. Let’s get into it.
Action Bias
Do you often react to every market movement to catch a winning trade? Simply put, that's action bias in action. In options trading, premiums often move steeply. Often, not all the time. Traders know this. Yet, this bias subconsciously lures options buyers into overtrading, driven by the need to be in constant action. Assessing the trend, identifying times where price is rangebound i.e. when you clearly know the edges, and resisting the urge to enter trades due to FOMO, could be some ways to circumvent action bias.
Overconfidence Bias
Conviction in trading cuts both ways. Amidst analyzing data and navigating market volatility, objectivity unfortunately takes a hit. When traders stick to their convictions without remaining objective, it's an overconfidence bias at play. Traders, under the influence of this bias, tend to believe they possess an edge, that they've figured out something the market hasn't, leading to a sense of invincibility. This bias leads to an overestimation of one's skills, risking larger positions, ignoring risk management protocols, and overlooking potential red flags, thinking they're infallible.
Curbing this bias is difficult, but with discipline, self-reflection, and humility are key. As a wise man once said...
"Doubt is not pleasant state but certainty is absurd" - Voltaire
A mindset embracing both success and failure fosters continual learning, essential in anyone's trading journey.
Confirmation Bias
As traders, most times we form a view even before we delve deeper into the data. Enter confirmation bias, the inclination to look out for data that aligns with our pre-existing beliefs. It’s almost like you look for only those signals that validate your view.
Let's take an example. Despite OI signalling strong resistance, your inherent bullishness prompts you to dismiss it and look at the price chart, simply because the latter offers some positive cues.
Now, this is one bias wherein human slippage is inherent. While traders’ quest for validation and confirmation signals is perfectly fine, what results in human slippage is the time you lose in juggling between multiple apps and jumping screen to screen — all for those few important data points. And in trading, time lost = money lost.
Where there’s a brain, there are biases.
