Sunday, 7 February 2016

Don't Be Your Own Enemy

This post is taken from where it was originally published. I am reproducing it here with some modifications. 

It is all about how biases mess with traders.

Every trader knows that emotions and psychology play an important role in trading. But the way our thinking influences our trading decisions goes much deeper than the regular talk about fear and greed. Evolution, our upbringings and day to day social interaction requires us to use psychological biases when making decisions; such biases have the goal to protect us and make the decision making process much faster. However, when it comes to trading, such biases can play against you because the way trading works is completely different from what is required in our daily lives.

Outcome bias

Let’s start with the most common bias; the outcome bias suggests that people only judge their actions based on the outcome of an event. When a trader has a winning trade, he made the “right” decision and when he has a losing trade, he made the “wrong” decision.
A trade where you violated all your principles, broke the rules, took too much risk and did not use a stop loss should never be considered “OK”, even if you ended up with a winning trade. Traders which operate in an outcome biased mindset often adopt false thinking which eventually leads to large losses and undisciplined trading.

Bandwagon Effect and Herding

Traders often flock together like sheep and it is especially common in today’s world of social media and constant interactions. Traders who exchange trade ideas with other traders in a forum, a trading chat, or through social media have a greater attachment to their trades. Especially during losing trades, such traders try to come up with reasons why it’s the right thing to stay in the trade even though it has already gone past their stop loss. They then look for other peoples’ opinion to confirm their position.
It’s OK to interact with other traders, but making decisions should be done independently and in private. The trader who asks, “why is it going down?” does not want to know why it’s going down, but he wants confirmation that the bearish move is short-lived and that his long trade is still valid.

Information bias

“More is better” isn’t necessarily true in trading. A trader in a losing position often consults other, starts using trading tools he hasn’t used before or looks for macro figures that could support his trade idea.
Once you have made a trade decision, all further decisions regarding that trade have to be made using the exact same tool-set and principles.

Ostrich effect

Smokers don’t care about the warning signs on their cigarette package enough to stop their deadly habit. The ostrich effect makes us block out negative information if it goes against our behavior; a smoker doesn’t want to feel uncomfortable every time he lights a cigarette.
Traders know that they should not keep adding to a losing position and stop widening their stop loss order. Still, they do it because it helps them avoid the realization of the loss. Staying objective and realistic is important to avoid disasters in trading.

Hindsight bias

After closing a losing trade, do you look for reasons why the trade did not work out? Making adjustments to your trading system on a trade to trade basis always leads to inconsistent results. As the outcome biases suggested, not all losers are bad and have to be avoided; the best setups will fail over and over again.

Recency bias

Risk management and position sizing mistakes are often caused by the recency bias. Traders often judge their trading system and their abilities based on their most recent trades. A trader with 5 winners in a row might get overconfident and a trader in a losing streak is more likely to risk more to make back the losses faster. It’s important to understand that trading is a long-term activity and that over the short-term, your results can undergo swings.

Psychological biases are hard to control or even change; they are engrained into our DNA throughout evolution. Unfortunately, in trading, biases work against us. Thus, you should not try to fight the biases in your trading; instead, start paying more attention to HOW you make your trading decisions and be aware of the voices in your head when you are about to make a trading decision that seems to violate one of your principles.


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