While past experiences and personality traits determine biases, there are proven techniques for managing cognitive biases.
In this article, we will explore the cognitive biases in trading with four case studies.
LTCM Case Study
The Long-Term Capital Management (LTCM) case study involves a hedge fund founded by Nobel laureates and finance experts in 1994 to trade global bond markets. Spectacular success in the initial years, the world’s top pedigree and sophisticated mathematical models fed to the overconfidence in 1998 bond arbitrage. The symptoms exhibited for overconfidence were high leverage and ignoring warning signs of the trade going wrong.
Brilliant people undoubtedly led LTCM, but unforeseen events and systemic risk triggered its collapse, which led to a $3.6 billion bailout.
The LTCM case study is worth pondering how overconfidence bias can infect even the brightest minds. Believing in your skills, strategies, and decisions is essential for successful trading. But overconfidence can lead to biased decisions and disastrous results, as in the case of LTCM.Shift in Market Regime in Options Trading
The COVID era (2020-2021) was a golden period for option arbitragers and traders. Even newcomers made easy money by executing strategies that captured theta by selling options. Many newcomers started to believe that their success was entirely due to their acumen and skills. Trading is a game of probabilities. Attributing recent success entirely to one’s skill leads to the trap of Self-serving bias.
When the market regime changed from 2022 to 2024, many option sellers who started in the COVID era lost heavily. Changes in the market regime were:
India VIX (volatility index) dropped from 20+ levels to around 10. This reduced the premiums, and the theta also declined.
The underlying index (Nifty) increased by ~45%, increasing short-term fluctuations. Even a 1% move in Nifty Futures could relatively trap option sellers, because of higher price.
However, those who attributed their success in the COVID-era to partly luck and partly skill could adapt to the new market regime by changing their strategies and trading style.
Overleveraging
Leverage allows traders to control larger positions with less capital. Options provide the highest leverage among all listed contracts.
Leverage can amplify both profits and losses, but biased traders tend to focus on profit potential while ignoring the amplification of losses. Slippage costs, transaction costs, and opportunity costs increase overall losses but reduce the profits.
The following causes are typically at play when a trader indulges in excessive leverage:
Overestimation of oneβs skills and expertise
Underestimation of risk
False sense of control over unpredictable variables that move the market (called the illusion of control).
Overconfidence from recent success (called recency bias)
When a biased mindset meets leverage, the result can be devastating.
Overtrading
Overconfidence bias can lead to a false sense of control through one’s strategies, tools or techniques. This results in overtrading, believing that every opportunity is worth seizing.
Overtrading can be identified by placing more trades than allowed by prudent risk management, unnecessary monitoring of market fluctuations or paying more in transaction costs than expected profits.
Instead of waiting for setups as per trading strategy, the overconfident trader jumps into trades impulsively, hoping that they can outperform the market through more number of trades.
5 Ways to Manage Cognitive Biases in Trading
Take psychological self-assessments to identify your personality traits and biases. Stay informed and objective about your strengths and weaknesses.
Document your trades with rationale and outcomes. It will help you to identify patterns in behaviour and avoid emotional decisions.
Stay aware of your thoughts, emotions, and aspirations. World-renowned trading psychologists such as Brett Steenbarger, Van Tharp, and Mark Douglas advocate the practice of mindfulness.
Create a trading plan that you can comfortably execute according to your personal preferences. Follow your trading plan ritually.
Engage locally with peer traders to share experiences and seek feedback.
(The author is CEO of Stoxkart, which also provides Stoxminda.ai, a trading behaviour assessment tool. Views are own)
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