In any activity where we need to make decisions, particularly under pressure, we are likely to display bias. A bias is a tendency to make a certain decision in a particular way. For example, if we prefer to pick tails over heads when flipping a coin, this is bias. Some biases can have severe negative implications for your trading performance.
Why do we make biased decisions?
Behavioural finance is a field between psychology and finance that carries out research into the prevalence of bias in decision-making. A key concept is the idea of ‘heuristics’ – simple rules of thumb we use to make decisions as quickly as possible.
Because in the real world we normally don’t have all the available information, and don’t have time to consider all sides of a proposition, this is a life-saving skill which allows us to adapt to difficult and dangerous situations.
In trading, we also need to make rapid, accurate decisions, and biases often creep into our decision making. Particularly, and understandably, loss aversion can lead us to trade in an irrational way and damage returns.
It is important to understand what biases can influence your trading so that you calmly consider whether your actions in the moment fit in with your overall trading strategy, or if they may be driven by irrational impulses.
How does bias impact trading results?
Many new traders don’t consider how their own biases may impact their trading. Imagine a trader who develops a forex trading plan and immediately begins executing trades, only to find it increasingly difficult to stick to his original strategy as fear of losses mounts. This results in the original, back-tested and logical strategy being rejected in favour of an ad hoc, emotionally driven strategy which in nearly all cases is less effective.
Loss aversion is by no means an irrational bias. After all, the potential consequences of losing money are more significant for your mortgage, daily life and family than any benefits from improving trading performance would be.
However, in an activity like forex trading, we need to be able to make decisions in a non-emotional manner; this is why we only use an amount of money in our day trading strategies that we can afford to lose.
With this safeguard in place, we are free to follow a forex trading plan without any impact from fear of losses.
What are the main biases that affect forex traders?
There are several biases which damage forex traders’ returns. A non-exhaustive list of the most important includes:
- Excessive loss aversion
- Forex bias
- Doubling down, or regret
These have in common the fact that they can bias forex traders into making poor decisions such as removing stop-losses, increasing investment amounts on losing trades, or exiting successful trades too early.
Trading psychology focuses on controlling the fear of losses. A trader with excessive loss aversion will make errors such as exiting winning trades quickly and before he’s reached his pre-planned take profit level. This eats into returns, and after the cost of transactions can see them turn negative.
As with the related bias of overconfidence, certain people might be more prone to this particular bias. A very loss averse trader, ultimately, is nervous. He might avoid making good trades because he always thinks about what could go wrong. His idea of ‘an amount I can afford to lose’ is ten dollars. His position sizing reflects this, and 90% of his portfolio is held in cash.
Very experienced traders are more likely to have an accurate sense of their own emotions and confidence levels, and so should be less likely to fall into this bias, but it can affect anyone. Particularly after a run of losing trades, or in a general ‘risk-off’ market environment, loss aversion can get the better of even the most disciplined traders.
Overconfidence is the mirror image of loss aversion but is more dangerous. An overconfident trader has ‘a good feeling’ about every deal he makes; he is convinced more experienced traders are making mistakes; he’s never afraid to ‘trust his own instincts’. He will put large portions of his portfolio into risky trades, not setting stop losses or setting them far too low. His take profit levels are overambitious, bordering on deluded.
Overconfidence is corrected by losses. Though he might get away with it for a while, an overconfident trader will soon realise he isn’t as well informed as he thinks he is and adopt a humbler attitude. Provided he doesn’t lose all his money in the meantime, this is an important learning curve.
There are two dangers here: One is that the overconfident trader loses lots of money, gets frustrated and just quits trading instead of learning to be more realistic. The other is he realises his limits, panics and then becomes overly timid, moving straight from the behavioural finance bias of overconfidence to its opposite, loss aversion. As with loss aversion, being aware of this bias can help protect you from making mistakes with your portfolio.
Many traders develop an attachment to specific trades (such as long USD/JPY) or particular candlestick patterns. This is reinforced when they have a successful experience trading a particular pair or pattern.
Forex bias, sometimes known as pair bias, is when a trader exclusively trades the currency pair he is most comfortable with. It is important to remember there are very good reasons for this; in major financial institutions, traders will often be assigned to a single currency pair as it allows them to develop a familiarity with the way one market works, its participants and any influencing factors.
For retail traders, this is a little different. If you are always trading the same pair because of a past successful trade, despite not being an expert in that currency or just out of habit, you may be missing opportunities in other markets. You must always balance the benefits of deepening your expertise in a single pair with the cost of not expanding your knowledge about others.
Forex bias frequently takes the form of always trading the home currency as one side of the pair, which is quite rational since it allows traders to avoid exchange rate losses when closing their accounts. In other forms it is less advisable: If you are trading long AUD/NZD exclusively because your first trade on that pair was a win, it might be time to think about widening your horizons.
Doubling down and regret
A trader has analysed a currency market with both technical and fundamental analysis, created a winning, back-tested strategy, begins trading an affordable sum using a detailed forex trading plan, and a few weeks in spots an opportunity that meets all of his criteria. Every indicator seems to confirm his analysis. Delighted, he enters a short GBP/USD trade with a well-sized position, sets a stop loss, and waits to take profit.
Only it doesn’t work out. Despite all the technical indicators telling him the pair is overbought, and fundamental analysis supporting this, the price continues to move higher, hitting the stop loss. There seems to be nothing in the news that could be influencing the price, the pair continues to get more and more overbought, and he is confident that given more time he’ll be proven correct.
Many traders, wrongly, would cancel the stop loss. There are various factors at play leading to this error. A sense of ‘sunk cost’ in the time spent on analysis and preparation; confusion as to what you’ve missed in your analysis; hope that the trade will soon be proven correct, and the linked fear of missing out. Overconfident traders are particularly prone to this bias, so if that applies to you, be extra vigilant.
Trading without bias?
No-one can entirely rid themselves of trading bias, and it’s not even clear this would be desirable. The important thing is to be aware of how you make decisions, what rules you want to follow, and to be able to step back when you feel you aren’t applying your normal principles.
How Rakuten can help
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