Education > Forex - Step10

[SECTION 3.4]

Mind games

Stock and CFD traders don't just compete with each other in the stock and CFD markets. Sometimes there's an even bigger enemy in their midst. Themselves.

Traders can be emotional and irrational and though such emotions and instincts can lead to trading successes, they are more likely to result trading losses unless we learn to master them. This is why understanding trading psychology is important.

Many stock and CFD traders would like to compartmentalise their emotions. Unfortunately, that is impossible, and some emotions may even contribute to trading success. Because of this, you need to understand your own strengths and weakness, so that your trading style can be adapted to your inclinations.

In this section, you will learn about four psychological biases that may influence your trading results negatively. We'll also show you �what you can do to overcome them:

1. Overconfidence bias [SECTION 3.4.1]
2. Anchoring bias [SECTION 3.4.2]
3. Confirmation bias [SECTION 3.4.3]
4. Loss aversion bias [SECTION 3.4.4]

[SECTION 3.4.1]

Overconfidence bias

Overconfidence bias is an inflated belief in your trading abilities. Any traders who thinks that they know the business inside-out, have nothing more to learn and that fortunes are there for the taking, may well fall victim to overconfidence bias syndrome.

Dangers of overconfidence

Overconfident traders tend to get into trouble by either trading too frequently or by placing extremely large trades with the intention of making a killing. It's not inevitable, but an overconfident trader courts disaster.

Are you overconfident?

"Have you ever delayed or reversed a decision because you couldn't believe you could be wrong?"

�If you can't say yes to this question, then perhaps overconfidence is an issue for you. Similarly a positive response to the question, "Have I ever put more on a trade than I know is really prudent?" also indicates a possible susceptibility.

Tempering overconfidence

One way to address an overconfidence bias is to stick to a strict set of risk-management rules. These rules should limit the number of markets you invest in and the number of stocks or CFDs you trade at one time. They should also cover how much you are willing to risk on any one trade and how much of your account you are willing to lose before you take a break from trading and re-evaluate your trading strategy.

[SECTION 3.4.2]

Anchoring bias

An anchoring bias is a belief that the future is going to follow current patterns. When you anchor yourself too closely to the present, you may fail to notice dramatic changes in the offing.

Dangers of anchoring

Anchored traders tend to get into trouble as they wrongly believe that current trends will never end or that companies they've always favoured will never let them down. Because they are emotionally attached to a stock or CFD, they continue to invest in a way which is not optimal in changed circumstances. Each trade they make loses them more money because they are bucking the trend.

Are You anchoring?

"Have you ever lost money because you couldn't accept that a trend had ended?"

If you respond affirmatively to this, you need to be aware of anchoring tendencies.

Beating anchoring

One way to beat anchoring is to seek a new perspective. Look at different time-frames on your charts. If you usually rely on hourly charts for data, look instead at the daily and weekly charts to examine long-term trends as well as levels of support and resistance. You could also examine shorter-term charts to see if trends are reversing.

Broadening your perspective in this way will help you to avoid anchoring yourself to any one point.

[SECTION 3.4.3]

Confirmation bias

A confirmation bias is the habit of only looking for information that supports your beliefs. If you anticipate the price of Google (GOOG:xnas) is going to rise, for example, you will only really absorb news and data that back your belief.

Dangers of seeking confirmation

Traders who pursue confirmation of their convictions tend to miss warning signs that would otherwise protect them from unnecessary losses. Ultimately, this can only lead to losing money because decisions to buy or sell, or even to do nothing, are being made on false premises.

Do you seek confirmation?

"How often do you look for signs that you may be wrong in your analysis?"

�If you answer rarely or never to this question, you may be a confirmation seeker. You need to actively work to ensure that such a bias never interferes with your better judgment.

Defeating confirmation bias

One way to overcome confirmation bias is to find an individual or group with whom you can discuss your trading. Better that this is someone neutral and objective rather than someone who gives you the answer that they think they want you to hear. Traders with different perspectives and ideas will help you to be more circumspect. Sometimes your convictions will actually be reinforced by talking with other traders, but at other times, they may force a total, money-saving rethink.

[SECTION 3.4.4]

Loss aversion bias

A loss aversion bias is based on the theory that losing �1,000 will have a bigger impact on you emotionally than gaining �1,000 will. In other words, fear is a more powerful motivator than greed.

Dangers of loss aversion

Ironically, traders who fear losses are much more likely to hold onto losing positions than traders who are able to accept short-term losses and exit their trades. A reluctance to give up a losing position will not only cause you to incur bigger losses but also preclude you from finding better investments.

Do you fear losses?

"Have I ever held onto a losing position, beyond the point where I knew I should have quit, because I hoped the trend would reverse and wipe out my losses?"

If yes is your answer, then you are definitely susceptible to loss aversion bias.

Beating loss aversion

One way to overcome a loss aversion bias is to trade with physically-set (i.e. automatic) stop-loss orders. Many traders trade with just a mental stop-loss. When it comes to the crunch, they fail to act on it. As they let their emotions interfere with their better judgment, they try to justify irrational decisions that prevent them from quitting and cutting their losses.

In conclusion, as soon as you invest in anything you should set your stop-loss order. It should be physically set, operate automatically, and you should adhere to it.