Thinking

How cognitive biases will affect your trading

More than anything, trading emotions can hurt your account balance.

 

Or, as the famous trader Jack D. Schwager said in Market Wizards:

The key to trading success is emotional discipline. If intelligence were the key, a lot more people would be making money.

 

The wave of trading emotions

Emotions make us enter the markets at the wrong time. Exit at the wrong time. There’s the fear of missing out (FOMO). Emotions probably make us take wrong decisions in between as well. It is the reason we lose out, even when our trading strategy is solid. We are bound to make the wrong errors over and over again, unless we are aware of what’s working against us.

 

Trading cyclus

 

 

There’s a very good reason why this happens: our brain isn’t wired to make contrarian decisions! But that’s exactly what we need to do while trading forex. Evolutionary theory has made us think in a way that is beneficial for our species, but that exact method of thought will often not result in profitable trades. Additionally, research has shown that we have difficulties in changing our point of view when faced with new information. We also experience losses completely different than wins. The list could go on.

 

 

We need to have a deeper look at what makes us tick. Only when we have that figured out, we can look at the heuristics of these cognitive biases. We can then counter them and ultimately, become a better trader. Let’s have a look.

 

Trading, fast and slow

One of the absolute authorities on cognitive psychology is Daniel Kahneman. Kahneman is an Israeli-American psychologist notable for his work on the psychology of judgment and decision-making, as well as behavioural economics, for which he was awarded the 2002 Nobel Memorial Prize in Economic Sciences.

In his book “Thinking, Fast and Slow”, Kahneman has summarised decades of his research on cognitive biases and behavioural economics. The book offers a unique viewpoint on how humans – and thus, traders – think.

 

There are numerous cognitive processes that influence how we make our decisions. Being aware of those processes can help us in how we approach the forex market. It can help our trading strategy and trading psychology as a whole.

 

Book! Buy! Sell! Sell sm

 

 

Below, I’ve described some biases and heuristics, how they will influence your trading and how you can take them into account when trading forex.

 

The Confirmation Bias

Cognitive biases - Confirmation Bias

 

I’m listing this first because I’m pretty sure all forex traders do this. The confirmation bias is the tendency to search for, interpret, favour, and recall information that confirms preexisting beliefs or hypotheses. At the same time, information that doesn’t agree with those beliefs will be given a lot less attention. Even be ignored altogether! The confirmation bias contributes to overconfidence which, especially in a trading context, can be very damaging.

 

This happens when you analyse a chart and conclude that the price will go up. From this point forward, you will look for confirmation of a bullish price trend. Every indicator or price pattern you find will reaffirm what you already hold dear: price should go up! Any indication that the price might do the opposite will be mostly ignored:

 

This must be an uptrend!
Higher highs, higher lows. This must be an uptrend! I will now only confirm this view.

 

Whoops, ignored the bearish signals and only confirmed my own beliefs!
Whoops, ignored the bearish signals and only confirmed my own beliefs!

 

Instead, it could be very useful to take the opposite point of view. Ask yourself: “what reasons can I find that would validate the price going down?”. This aligns a lot with the negative thinking approach I outlined in my trading like an astronaut article.

It is such a powerful method of thought. This way of thinking isn’t natural, but forcing yourself to take the opposite standpoint will enable you to be more critical to the entry criteria of your trading strategy.

 

 

The Anchoring Effect

Trading cognitive biases - Anchoring

 

Anchoring happens when you rely too much on the first piece of information offered (the anchor) when making subsequent decisions. People base their decisions by adjusting away from the anchor, even though the anchor itself might not be rational to begin with. Being the first to name a price during negotiations is a prime example of anchoring, as it will set the tone for the rest of the talk.

 

In the context of forex trading, we will often use our entry price as an anchor. This means that when our trade is at a loss, instead of cutting our losses and closing the trade, we will rather wait much longer to hope and see the price go back to our break-even price, even though we are incurring much bigger losses than originally anticipated. The open price bears little meaning other than that it was the price we opened our order, but still we hold a certain importance to that level.

 

Another example is if we anchor on support and resistance levels. When we anchor on these levels, we are often completely unaware of other (more important) factors that could push the price beyond these levels. Holding on to an anchor can prove to be dangerous in trading, and knowing about these cognitive biases might make the difference between a losing and a winning trade.

 

 

The Bandwagon Effect

Cognitive biases - bandwagon effect

 

The bandwagon effect is a psychological phenomenon in which people do something primarily because other people are doing it, regardless of their own beliefs, which they may ignore or override. The bandwagon effect has wide implications, and happens often by looking at trading recommendations of other people.

 

Whole industries of signal providers rely on the bandwagon effect, where people take trades with the sole reasoning being that someone else took the trade. But this happens in much more subtle ways too. It might be enough to look at a tweet of someone influential recommending to buy EURUSD to tilt you over to that belief as well! You will be subjected to the bandwagon effect day in, day out.

 

While you can certainly listen to what other people have to say, it is important to always form your own opinion at the end. Blindly following others is not a proper trading strategy.

 

Conclusion

We make our decisions heavily influenced by various cognitive biases. If we know about these biases, we can keep them in mind and take more informed decisions. I’ve explained 3 cognitive biases above, but there are a lot more that can influence how you decide which trades you take. Have a search for the Dunning-Kruger effect, the Availability Heuristic, the Sunk Cost Fallacy, the Hindsight Bias and the Optimism Bias, to name a few.

 

If you want to know more about cognitive biases, I recommend that you read Daniel Kahneman’s book Thinking, Fast and Slow. It is an amazing read and you will learn a lot about how you make decisions.

 

Good luck and happy trading!

© some images Towergate Insurance

 

Have you ever encountered a bias like this? Let me know in the comments!

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Felix

I'm a full-time, independent forex trader. I've been trading for over 10 years and specialise in reversal trading, trading psychology, algorithmic trading and coaching others. When I'm not trading, I'll either be travelling the world or rock climbing (likely both). Read my story here.

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