Overestimating your memory
Most traders claim to have a very long term memory and would remember their first trade, their largest winning trade and their largest losing trade. Most would even remember the date, time or even the event that occurred that is associated with that memory. I however, still call this short term or selective memory. They only apply some level of importance to the most important trades or events and less importance to less important or less recent ones.
Imagine following a sport very closely. One of the players is loud and flamboyant and does a lot of interviews, while the other one keeps to himself and does not possess any remarkable visual traits and uses a very conservative playing style. Both of them, however, perform equally on average. If you are later asked to point out a better player from those two, you would instantly think of the more flamboyant one, as having a better average. Coming back to trading, this short term or selective memory can have a significant effect on the psychology of a trader.
Getting the wrong signals
Let’s take two traders who have similar profitability so far. They both trade using different strategies and in this example do not know of each other. Trader 1 has recently had 3 consecutive winning trades, while Trader 2 has had 3 consecutive losing trades. Even though both have made or lost exactly the same amount of money during the year so far, who do you think is more positive? The answer is obvious and most people would say it would be trader 1.
Both traders are now emotionally charged. On the one hand, we have Trader 1 who is feeling very positive and on the other hand is Trader 2 who is feeling a bit negative. Now let’s consider some of the effects of this emotion
Trader 1, on his next trade will potentially make one of two mistakes, since he is feeling invincible, he will potentially break one of his rules and increase the risk of having a losing trade or ignore one of the warning signs and still place a trade he normally would not have. Trader 2 on the other hand will also potentially make one of two mistakes on his next trade. Since he feels that he has had more than average losing trades, he will either break one of his rules and try and change a strategy that has in the past given him consistent profitability or he will not take a trade that has perfectly set up according to his own rules.
Coping with emotions
Of course, both traders have had their fair share or winning and losing trades along the way, but when the emotion comes into play, it can prevent them from making rational decisions that have otherwise helped them be profitable in the past. So, the question is how do we get over this emotion and prevent the short term memory from having an adverse effect on our trading. Here are a couple of simple tips:
1. Keep a record (diary) or traders log of every trade made and this should include how much was the profit or loss on the trade and what is the end equity as a result of this trade.
Keeping a record allows you to look at all your trades objectively over a long term basis and avoid making wrong decisions based on your short term memory
2. Keep a checklist with your trading criteria and if possible include that criteria or strategy into your diary.
If you follow your checklist on every trade and make it mechanical, you are less likely to enter a trade that does not meet your own criteria.
3. Know yourself as an emotional person.
Keep it cool
It is extremely important to handle emotions. If you are able to cope with them quickly, it makes sense to get back into trades soon, after you have overcome the emotional shock or euphoria from the recent trades. However, if it takes you longer to get back into the swing of things, then it is better to wait.
It is a big challenge for most people to overcome their short term or selective memory and, more importantly, to overcome the emotions attached to them, but if you get back into trading without having overcome them, you can risk more than you will potentially gain and significantly shorten your trading life span.