The Challenges of the Egotistical Trader

When one decides to trade for a living, they often immerse themselves in books and classes, spend countless hours on the internet doing research or perhaps talking to fellow traders. They learn technical analysis, computer programming, stock fundamentals, they study economic indicators. They search for patterns in things. They go with the trend, they fade the trend. In the end, very few of these people will ever be successful at trading. What's even scarier, is that when they fail, they often have no idea went wrong. Usually when people fail at something, they know exactly why. They might not have been able to do anything about it, but at least they know what it was that was their downfall.

But with trading, most people let their egos get in the way and they spend all their time trying to "figure" it out. The answer, the grail, the secret indicator, but they spend no time looking at themselves. Trading is really an endeavor into human psychology. When you understand how crowds think and how the behavior of the masses move the markets, it becomes much simpler to trade then all the indicators in the world.

Without going into a complete dissertation into psychology, I'm going to suggest you play a game. It's a very easy and simple game. This game will demonstrate to you the forces of human nature that are working against you when you are trading. The rules of the game are very simple. It's called the bargaining game. It requires two people. Try to pick someone as competitive as yourself. Here are the rules to the game. Both you and your opponent will bid for a $20 bill. You can bid whatever you want. Both you and your opponent are required to make at least one bid. You will flip a quarter to see who goes first. Now here's the catch to this game. Whoever the highest bidder is, gets the $20 bill. But, the loser has to pay his or her last bid.

So let's use an example here. Say I am playing Mr. X and I go first. I bid $1 for the $20 bill. Now Mr. X is required to make a bid. He obviously is going to outbid me so he bets $2. If we stop right now, Mr. X bought the $20 bill for just $2 and I have to pay out $1. Obviously it behooves me to make another bet so I bet $3. Now I am the highest bidder. Why did I make this bet? Because I immediately went from losing $1 to making $17. Now Mr X has just lost his $18 profit and now has a $2 loss. I don't have to tell you he is a little upset right now. So what does he do? He bids again, this time $4. Now he went from a $3 loss to a $16 gain and I am now in the hole once again.

I think you see where this is going. You see, it's always in our best interest to make another bet because we will be going from a losing bet to a winning bet and by doing so will be putting our opponent on the other end. What ultimately happens in this game is both players find themselves bidding more then $20 for the $20 bill. Well that sounds crazy doesn't it? Well, it is and isn't. To each player, he sees each additional bid as an opportunity to recoup his losses and put his opponent in the hole. For example, when I bid $30 for the $20 bill, it might seem stupid to you, but I am going from a $28 loss to now only a $10 loss. I am making back 2/3 of my losses right? Why is that not a good deal? Well, it becomes obvious why it's not a good deal when your opponent realizes the same thing and outbids you yet again. So how do we get out of this neverending mess? Well, it requires one of the players to swallow their pride and take a loss. But by doing so, you are letting your opponent of the hook. Most people have a very difficult time with this proposition. Because our ego gets in the way. We just can't take a loss and admit we got beat. So what do we do? We dig ourselves deeper and deeper in the hole.

So what is the optimal way to play this game then you ask? It's simple. If you lose the coin toss and are forced to make a bid after your opponent, you cut your losses immediately as you will realize that any further bets you make could bankrupt you. You are better off paying $2 for the loss and letting your opponent walk away with the $20 bill with a mere $1 bet. Yeah it's hard to do that, but it requires you to lose your ego.

Now I can see what some of you are saying. If I played that game for $20 I would be smart enough to give up after a few rounds and I would move on. Hell, it's only $20 right? Well, perhaps. But what if we changed it to a million dollars. That's right, you and your opponent now have the opportunity to bid for a million dollars. You could pay off your mortgage, your student loans, your credit card debts, travel around the world, live the good life. You can see the images in your head. I mean who wouldn't bet $1 to make a million. So of course you bet. But do you think your opponent is going to let you walk away with a million dollars! Not unless she has lost her mind. Now she is probably saying to herself, I'll bet, but I'll stop when it gets too high, say $500. So she bets $500 for the million and now you just lost all your dreams. Are you going to let this woman walk away with a million bucks while you are stuck paying out $499 in losses? And round and round we go. Now things get really ugly and you find yourself out of control losing everything.

This game demonstrates some of the obstacles every trader faces, his own ego. His need to be right. Many times we find ourselves in a trade unwilling to get out because we know we will be right eventually. We are unable to stop the losses from mounting, because doing so would require us to swallow our pride and admit defeat. But like the bargaining game, the optimal strategy is to just cut your losses and play the game again. Keep doing this until the game works in your favor. It's very hard for most people to see this.

This game by the way doesn't just apply to trading but in all sorts of facets in life. The game is taught to many people in college so they can understand the process of self destructive decision making. For example, take a couple who has been married for ten years. Things aren't going well and the optimal solution at this point is to separate. But one or both parties says to themselves, I can't leave now, I have invested too much time and money and energy into this, if I leave, all will be nothing and I will have to start all over again. The same principles apply here. Both parties stay together because they feel that they have past the point of no return and too much will be wasted if they split up. So what they do? They stay together in a self destructive marriage until one of them shoots the other.

What about somebody that starts a business? Same thing. They invest all their money, all their time, into something for years. At some point they realize the business is never going to work but they don't want to admit it. So they keep trying to make it work even though they are essentially caught in a bad trade. The idea of quitting, taking your losses, and starting all over is just too much for most people to bear. So they stay at it until the bank forces them to quit.

As you can see by the bargaining game, very few people have what it takes to see the fallacy of their own ways. We take pride in the decisions we make and we never want to admit we are wrong, or stupid, or ignorant, it's much easier to just keep playing. And as the trade continues to go against you and the losses continue to mount, you always are able to justify staying in. Just as the person in the $20 bill game justifies that by placing another bid they are essentially cutting their losses, albeit temporarily.

So what can we learn by this? We have to understand the importance of controlling self destructive behavior. Because in the end, even if we make perfect trades, if we let our ego get in the way, it's only a matter of time before we lose it all. So the next time you are out with a friend, pull out a $20 bill and let the bidding begin. This is how you will find out what kind of a trader you are. It could very well be a cheap education for you.

If you ever read Liars Poker, you will read about this game being played.
(Copied from optionstraders.blogspot.com)