Trading Psychology: Confidence vs. Profit Potential and Risk Ratio

You've probably heard this situation before, or perhaps you've experienced it yourself: a trader spends a long time chasing a buy signal for a specific stock or security. When the price finally begins to approach the buy levels set by the trader, they initially hesitate – unsure if it's a buy signal, or if it's better to wait a bit and make sure the price will actually move in the desired direction. Only when the move seems clear and "certain," and the market is buzzing with positive news, do they decide to open a position. Unfortunately, they enter only halfway through the movement, when a large portion of the potential profit has already been realized. Such a late trade has a much worse effect. risk-reward ratio than the previously set entry level, and in addition, it is not certain that the price will ever reach the exit levels set by the trader (or that the trader will actually be able to exit at that level).

This example illustrates the trading paradox: The more confident a trader feels about the market direction, the smaller the profit potential usually remains relative to the risk incurred.In other words, the signal worked, the move happened, and those who dared to enter first reaped the reward.

How do you balance confidence in the quality of a signal with achieving a good reward-to-risk ratio in trading? This is what this article is about.

Feeling confident in trading – the psychological sources of the phenomenon

Why is it that the greatest certainty often means the least profit? The answer is provided by, among other things, investment psychologyThe first culprit is confirmation bias (Ang. confirmation bias), i.e. the tendency to subconsciously seek information that confirms our already established beliefs. A trader with a strong market thesis will selectively focus on signals that confirm him in his opinion, while ignoring or discounting contradictory data. If they believe the market is about to rise, they will more easily spot all bullish signs and downplay potential warnings. This one-sided filter often delays the moment of entry into a position, as the trader waits for most signals to "agree" with their vision. Unfortunately, by the time this happens, the move is largely exhausted.

The second factor is overconfidence bias, or investor's overconfidence. It's a tendency to overestimating one's own skills and the accuracy of forecasts, which leads to taking too much risk and ignoring proper position management, including the importance of timing and the location of position entry. In trading, overconfidence often grows with the visibility of price movement – ​​the longer and more clearly the market moves in one direction, the more people are convinced that they "were right" and the trend will continue. When, for example, stocks are rising rapidly for the fifth session in a row, it's easy to succumb to euphoria and believe that this is the "obvious direction." Traders become increasingly confident because the market seems to confirm this with each subsequent day of growth. However, this confidence is illusory. Psychologically, it is associated with the illusion of control, i.e., the impression that we have a greater influence on the outcome than we actually do. In practice, this manifests itself in the trader overestimating their ability to predict movement and no longer accepting that they could be wrong. This phenomenon leads to It is easy to ignore warning signals and enter into a transaction with a delay, but with great confidence in its correctness. The mechanism is as follows: as price moves, the conviction in the investment thesis grows → the rising price causes the growth potential to decrease and the risk to increase → the trader enters a position late, which results from the growing conviction in the validity of the transaction → the transaction is concluded with a worse risk-to-reward ratio, which doesn't necessarily have to end badly on a one-off basis, but with the increasing number of such transactions, the probability of loss for such a trader increases. He has developed a system in which when he is right, he makes little money (because he is late), and when he is wrong, he loses a lot (because he did not enter into transactions at the level he set). In other words, a trader only feels comfortable when "everything points" to success, which means he enters very late, limiting your potential profit to a minimum while exposing yourself to the full risk of the transaction.

Certainty vs. Profit Potential

How does this translate into practical trading? The clash between earlier and later entry signals is best illustrated by the difference in the potential R/R (reward-to-risk ratio) mentioned above.

Let's consider the following scenario: a trader sees that BTC price is currently trending sideways and approaching a key level on the daily chart. The trade idea is as follows: the trader assumes that a breakout of this level (1D support) could signal further declines to the next key level (1D swing high previous ATH). So, they decide to take a short position, but at what point should they take it?

The trader is considering the following options:

• Concluding a transaction at the “1D support” level;
• Entering a trade when this level is broken and the candle that broke it closes.

So let's analyze the risk-reward ratio the trader achieved in both cases.

In the first case, the reward-to-risk ratio is excellent at 2.04. The risk of this strategy, however, is that the price will rebound from the "1D support" level, as it has done twice already, and the trader will be forced to close the position at a loss.

In the second case, the trader's investment thesis is confirmed by the close of the candle that broke through the "1D support" level. However, as we can clearly see, if the trader had entered a position based on this reasoning, the reward-to-risk ratio would have been very unfavorable, at 0,37. So, in this case, the trader gains confirmation of their reasoning, but loses a large portion of the expected move.

It follows from the above that waiting for certainty costs moneyIn essence, the trader pays for the comfort of certainty about his thesis by losing some of the profit he could have made.

Certainty vs. Profit Potential – Consequences for the Trader

Such trading habits naturally have consequences. First, a trader accustomed to entering "after the fact" will be chronically late. Constantly chasing the speeding market train means many opportunities are lost. Investors miss out on prime entry points, waiting for more confirmations than may be necessary. As a result, the effectiveness of their strategy suffers.

Secondly, late entries provide a false sense of security. Yes, when entering a position, it seems that "the trend/signal is obvious," so the risk of failure is minimal. However, when something becomes obvious to all market participants, it often means that most interested parties have already taken positions, and the next move may be the oppositeSuch overconfidence lulls one into a state of alertness.

Thirdly, the already mentioned long-term effect of the described phenomenon is reduction in the profitability of the strategyEntries made only in the comfort zone (i.e., with high confidence in the move) usually offer a poor reward-to-risk ratio, as in the examples cited. This means that even if the trader is right about the direction, he or she earns relatively little in relation to the risk he or she has taken. However, when the inevitable mistake occurs (a In trading, mistakes are inevitable), a loss from such a late trade can wipe out the profit from several earlier small wins. Furthermore, missed opportunities from  high R/R (the "uncomfortable" ones, because they are not fully certain) are lost, and potentially large losses do not disappear from the radar and with a bit of inattention, they can appear.

How to counteract the confirmation trap?

Is it possible to avoid this trap? Yes, but it requires discipline and self-awareness.

Accept the discomfort of uncertainty. We have to come to terms with the fact that some good deals will be psychologically uncomfortableThe best setups often come when uncertainty prevails, not when everything is clear. If your trading plan gives a signal and the conditions are met – act, even if you feel internal resistanceThis resistance is nothing more than the natural human need for certainty. Professional traders learn to embrace it. They know that trading is a game of probabilities, where there's never 100% certainty, so some discomfort upon entry is normal. Furthermore, it's often said that "if you're too comfortable with a trade from the start, it's probably bad." However, the most profitable trades can be difficult to execute precisely because most people hesitate at the moment of entry. By accepting risk of failure (which comes from having a good risk management system) and the fact that the market can do something unexpected, you stop being paralyzed by the need for absolute confirmation. You act according to a plan, not the mood of the moment.

It is also worth conducting trading journal and analyze entry moments. Self-discipline is born from self-reflection. A detailed trading journal is an excellent tool for developing it. Record each entry – what the signal was, whether the plan conditions were met, what the assumed R/R was, what your emotional state was (confidence, doubts), and, of course, the outcome of the trade. What will this give you? First, you will gain an objective record of your decisions, something you can return to coolly. Secondly, you will reveal patterns of behavior that you may not notice at first glance.

By analyzing your journal, for example, weekly or monthly, you may notice:

"Hmm, I only entered most of my losing trades after a big move, when I felt confident, so I fell into the trap of late entry again. Time to develop a better positioning strategy."

Or vice versa:

"The most profitable trades were the ones I was initially concerned about. However, with the right stop loss, I can handle the risk."

This self-knowledge is invaluable. Recording and reviewing your trades provides critical insight into your strengths and weaknesses, ultimately helping you make better decisions. If you regularly notice that you're not sticking to your plan or that you're entering too late, you have the opportunity to consciously correct them. A journal also forces you to be more accountable for your decisions (if I have to write down why I'm entering now, I'll think twice about whether I'm doing it for the right reasons). Combined with a plan and discipline, journaling becomes a tool for continuous improvement and protection against your own mistakes.

Summary

As a trader's subjective confidence in market direction increases, the real profit potential of a given position decreases. In other words, Growing confidence in market direction = worsening risk-reward ratioConfirmation effects and overconfidence push investors to act only when they feel "safe," although this safety can be illusory.

How to counteract this? First and foremost, one must accept the risk, market uncertainty, and the discomfort a trader experiences when taking a position, stemming from this very uncertainty. Trading is a game of probabilities; we will never be certain of the validity of a position unless after the fact or due to acquired knowledge. “insider information” (although this is, of course, illegal). A trader's journal and meticulous recording of setups and market entry methods can also help. As a rule, over time and practice the art of taking a position at the right place and time (and therefore also with good R:R) becomes much clearer.

Professional trading is all about consistent implementation of your strategy even when things aren't clear, because that's when the best moves are born. After all, certainty is the enemy of profits, and the ability to operate in conditions of uncertainty is one of the key features of winning traders.