Lesson 19: Correct Mindset: Probabilities = Edge

Probabilities lie at the heart of all successful trading. To ensure that we a thinking in probabilities throughout our trading day we concentrate on 3 things.

1. Patience: We understand that the best time to trade is when price is Overbought or Oversold, as these areas represent when a move is near exhaustion and is most likely to reverse. This requires patience, as we must wait for price to become OB or OS to have an edge.

2. Execution: From backtesting our strategy we understand that it’s impossible to predict which trades will be winners. We accept we can't predict the future and focus solely on correct execution to give us our edge. Good entries and exits not only increase our profits, but also limit our losses should our trades go against us (stop loss / trailing stop).

3. Honesty: We understand that in business losing is not always losing and winning is not always winning. This honesty give us an edge by allowing us to avoid trying to fix trades in which there were no errors (ie: losing trade with correct money management, entry and stop placement) or emulating trades in which there were mistakes (ie: winning trade with poor entry, exit and/or money management).   

If we can conduct ourselves with a bias on Patience, Execution and Honesty then we are thinking in probabilities and even losing days are good days because we are trading with an edge.

Lesson 18: Overcoming Cognitive Biases = Backtest

As we trade we will come up against some emotional barriers (biases), they are...
1. Loss Aversion: to have a strong preference for avoiding loss over acquiring gains. When self employed we must be both risk takers and bank managers (risk avoiders), this internal battle represents loss aversion. To overcome it we backtest our strategy to prove to "our" bank manager the business is viable.

2. Outcome Bias: to judge a decision by its outcome, rather than the quality of the decision at the time it was made. This is easy to slip into as we are brought up with a bias on test results (school/work). The problem is tests are based on absolutes and established facts, but business works in probabilities because the factors effecting it continually change. To overcome it we must examine our backtesting to learn its "win/loss ratio" and "max losses in a row". Once we have the facts we know when to ride out a rough patch and when to worry.
3. Recency Bias: to favour recent results/data over older ones.  It occurs after a string of positive or negative results, when instead of accepting the fact that in terms of probability we have just been incredibly fortunate or unfortunate, we start to believe that we are truly gifted or cursed. This bias is a sibling of outcome bias, so is dealt with in the same way.

4. Disposition Bias: to let losses run and take profits early. This is a by-product of greed, fear and inexperience. Greed makes you hope a loser will turn around. While fear makes you quit a winner early, in case your gains reverse. Solution, you've guessed it backtest. Everyone overreacts when they don't have the facts.
Once one's overcome Disposition Bias, problems usually start with Recency Bias (string of losses), leading to Outcome Bias (focusing on results) and finally to Loss Aversion (doubting the strategy). When this happens stop trading and do a day or two of backtesting, this helps tune you back into reality and your strategy.