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Based out of Auckland, New Zealand, we bring an institutional trading experience to the retail market.

Biases are shortcuts that your brain takes to wiggle around complicated or tough decisions. They can have a huge impact on your day-to-day decisions. While this isn’t usually a huge problem, your biases may be holding you back from success in trading.

The human brain wants to conserve energy, and to do so; it will take shortcuts to avoid sensory overload. These shortcuts are often just fast mental decisions or shortcuts known as “heuristics”. The real problem with this is that we’re typically unaware that we have these biases. We must work hard and constantly challenge ourselves to counter the adverse effects that heuristic biases have on our trading and everything else.

While there are many forms of biases, let’s focus on two that have a disproportionate effect on your trading success. For these purposes, we must focus on cognitive and emotional biases. These biases are studied in the field of psychology. More recently, they’ve also been studied in economics and the new and valuable area of behavioural finance.

After seeing the effects of these biases on my trading and the trading of my colleagues, I noticed that seven key biases have a disproportionate influence on an individual’s trading. As you read on, try to ask yourself how these biases may have impacted your trading. Then, think about the ways you can prevent them from affecting your future trading.

  

1. Confirmation Bias

Confirmation bias causes us to seek out information that agrees with what we already believe and disregard information that suggests the opposite. Ask yourself, “How many times have I placed a trade then sat there and watched it go against me?” This happens occasionally, but when it does, where do you go to find information on why it happens? Are you seeking “expert” advice that tells you that you were always correct?

A colleague once told me; "many years ago, when I first started trading, I placed a large trade on oil. In hindsight, I didn’t know what I was doing, and the trade was too big for my account. I made a few mistakes as a beginner, including frantically typing “oil” into Google looking for any reason to support my original opinion that the price of oil would go up. Low and behold, there were investment banks providing information that agreed with my initial assessment. They talked about an undersupply in the market, explaining that oil was sure to go higher. It was 2 am at this point when I watched my whole account go into jeopardy. This valuable advice that I sought helped nurse me to sleep."

Of course, none of this was beneficial. My colleague deviously chose not to click on any article that might tell them that they were wrong. They only sought out the information they wanted to hear or see. 

 

2. The Endowment Effect / Sunk Cost Fallacy

trading

The endowment effect is a psychological state that you enter once you own something for a long time. Effectively, this means we tend to value something more after we hold it for some time.

This “endowment effect” has been studied extensively. The studies and experiments concluded that we fear losing what we own so much that we place an abnormally high value on what we own.

Our loss aversion can have a significant impact on our trading success. For example, imagine placing a trade on EUR-USD, targeting a profit or loss of only 50 pips. Then, when the trade starts to go against us, what’s the first thing we often do? Move our stop loss further out because we “just know it’s going to turn around.” We tell ourselves stories like, “The Euro is cheap here; it’ll turn around.”

At this point, our commitment to this trade has caused us to allow it to become a sunk cost. We value it more because we own it and because we have already invested in it.

  

3. Recency Bias / Availability Heuristic

The “recency bias” or “recency effect” tells us that our recent experience can become the baseline for what will happen in the future. The human mind likes consistency and predictability, after all.

You can become a victim to this form of bias because of recent solid trade performance, such as a recent win or loss impacting you heavily. It can also come from a particular piece of news or information we recently heard, which then forms the basis for our decision making.

For example, imagine I gave you a list of items on a shopping list and then asked you to recall it. Chances are you would tend to only really remember the things at the end of the list. This form of bias can have dangerous consequences for us as traders. It undermines our ability to form an objective decision on a trade. This is because we tend to focus too much on our most recent trade or information we found as a barometer for how the next trade will go.

We also tend toward the fear of missing out (FOMO). With this new information, we feel we must put something into action!

So, how do you overcome this bias? As difficult as it may be, you must stop and count to three and ask yourself a few questions:

  

4. The Gambler’s Fallacy

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The gambler’s fallacy kicks in when we believe that previous events alter future probabilities. This effect is known as the “gambler’s fallacy” due to behaviour often observed in a casino. Imagine a roulette table; every time the game is played, the ball somehow lands on black repeatedly. Onlookers see this happen and think, “it couldn’t possibly land on black again”, and proceed to bet against it.

As traders and human beings, we tend to believe that if something happens multiple times, it couldn’t happen again. We thus ignore simple probability.

As an example, a bit closer to home, let’s say the S&P500 has rallied for five days in a row. So, we place a trade in believing that “it must be due for a correction” only to watch the index rally for the sixth day.

If you want to combat this bias, it’s essential to look at the original factors that got you interested in the trade.

  

5. The Bandwagon Effect

The “bandwagon effect” describes our inclination to do or believe things just because others do or think the same. Also known as “groupthink” or “herd behaviour”, it can lead to a severe trading hangover. During your trading hangover, you ask yourself questions like, “why on earth did I go long on the EUR-CHF last night?”

A recent example of this effect was the Federal Reserve’s first-rate increase since 2008 by December of 2015. Following the event, commentators and fund managers surveyed by Bank of America-Merrill Lynch said, “buying US Dollars was the biggest one-way trade of 2016”. Most respondents believed the general market consensus that because the Federal Reserve said they expected four rate rises in 2016, the USD would surely rally.

Following that long USD trade would have led to disaster. In fact, the USD-JPY fell from as high as 121 to 101, an impressive 2000 pip fall from December! Be careful of those bandwagons!

  

6. Hindsight Bias

Everything is more apparent in hindsight. You could also call this bias the “I knew it all along” effect. How many times have you heard someone say those words in life, let alone in trading? We tend to believe that the onset of a past event was entirely predictable and obvious, even though we couldn’t predict it during the event.

Due to another bias called “narrative bias,” we tend to assign a narrative or a “story” to an event that allows us to believe that events are predictable. We like to think that we can somehow predict or control the future. It allows us to make sense of the world around us. It is now common to find stories of those who predicted the great recession and the US housing bubble in hindsight. They become legends or “oracles” that people look to in the future for advice, believing they will again be able to foresee any future turmoil.

It is essential to watch out for this bias. The hindsight bias leads us into perhaps one of the most dangerous mindsets: overconfidence. 

  

7. The Overconfidence Bias

The overconfidence bias is our final bias and one that is typically less hidden than the others. Overconfidence as a trader allows us to believe that we are superior in our trading. This ultimately leads to hubris and poor decision making. It doesn’t matter whether it’s overconfidence on when to trade, what to trade, or how to trade a particular product.

This can all lead us to trade larger than we should, hold losers for longer than we should, or relax our risk management policy. Of course, this all leads to capital losses.

 

What’s Next?

OK, so I might have scared you. You may be jumping at shadows and questioning your own trading decisions, believing you have all these secret, hidden disadvantages that you didn’t have until 10 minutes ago, but don’t worry. Biases can not be completely avoided, but we can work hard on challenging our opinions to make us more successful. Sometimes all it takes is just a moment to stop and think.

To help you along the way, we’ve created a possible checklist for making better decisions in your trading.

So, stop, take a breath and ask yourself these seven questions before you place your next trade.

1. Why am I taking this trade?

2. How strong is the evidence behind my decision to trade?

3. Could I be missing something?

4. Is there evidence to consider the opposite side?

5. Has the recency of information I’ve learned influenced my decision? If so, how much?

6. Is this trade following the consensus of the crowd? If so, is that a good thing?

7. If none of the above questions applies, could any of the other biases above be at work?

"If you have more than 120 or 130 I.Q. points, you can afford to give the rest away. You don't need extraordinary intelligence to succeed as an investor"

Warren Buffett.

Forex trading is not rocket science.

A simple set of guidelines can empower aspiring traders to overcome the learning curve and become consistent in a relatively short time. These same guidelines have worked for generations. Back in the early 1900s, Jesse Livermore used the same guidelines to make his fortune. However, many would-be successes have failed for easily understandable reasons.

Most traders fail to respect these basic yet essential rules:

  1. Follow the trend
  2. Sit on your hands until there is a trend to follow
  3. Cut losses as soon as logically possible
  4. Let winners run as long as logically possible
  5. Know Your Indicator

In this article, we'll review the basics to convey how these guidelines keep traders out of trouble.

1. Follow The Trend

"Follow the trend. The trend is your friend"

Jesse Livermore

Most retail traders have trouble following trends. Often, when a trend is developing, retail traders fight it, attempting to pick tops and bottoms. It's a repetitive habit that a sentiment trader illustrates systematically.

Evidently, many traders have trouble identifying a trend. That's understandable, as depending on how a trader looks at their charts, multiple trends can coexist within the same currency pair simultaneously! It's rare to see currency trending in the same direction on all time frames. It does happen when momentum is strong or driven by news, but the ebb and flow of the market tends to confuse traders that use multiple time frames.

For example, a currency pair may simultaneously seem to be trending upwards on a daily time frame and trending downwards on a 1-hour time frame. The same pair may also appear to be largely range-bound on a 5-minute time frame.

When trading from the retail angle, keeping things simple is generally best. Here are three suggestions for identifying a trend:

 

2. Sit On Your Hands Until There's A Trend To Follow

"If most traders learned to sit on their hands 50 per cent of the time, they would make a lot more money"

Bill Lipschutz, Market Wizard.

The second essential guideline in trend trading is to "sit on your hands" and refrain from trading until there is a clear trend in place. Of course, there are other ways to trade that don't rely solely on trends for their edge. However, retail traders often have part-time or full-time jobs, restricting the amount of screen time they can get. Furthermore, the time constraint reduces the available time for pre-trade analysis.

The bottom line is that retail traders are better off being light on their feet. Keep the analysis method simple and keep the trigger criteria equally simple. Trend trading fits the bill because it only takes a few minutes each day to filter the quality trends in the market. It's key to avoid trading trendless charts where there's no edge.

 

3 & 4. Cut Losses as Soon as Logically Possible & Ride Winners

Have you ever held onto a losing trade, thinking that the market "had" to turn around sooner or later? Many traders have been there, but this is in direct violation of a rule we simply can't ignore: cut losses quickly.

We should always cut our losses quickly. Likewise, we should always hold onto our winning trades for as long as logically possible.

The process of monitoring your trade after the initial entry is called "trade management". Trade management is an area that is not covered in detail in classic trading books. It's all about entries and exits. But how do we formulate a plan that helps us cut losses as soon as logically possible, but not sooner? And how can we know when to hold?

The basic idea is to let the market dictate when it's OK to hold and when it's time to fold. Simple tools that can help with managing trades are:

Without a consistent structure for managing your trades, it will be a struggle to keep your emotions at bay and "trade what you see".

 

5. Know Your Indicator

"I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail"

Abraham Maslow.

Some traders rely solely on indicators such as support and resistance lines. But some traders prefer to overlay technical indicators on their chart to assist with decision-making. That's fine, but many traders fall into the trap of "covering" their charts with technical indicators without knowing:

Unfortunately, without knowing this, it's impossible to use any indicator properly. It's also hard to know when the indicator might be giving false signals. Technical indicators are just tools. Without a good understanding of what your "tool" does, you won't know when or how to use it.

Many traders attribute more importance to indicators than they deserve.

To make this point even clear, observe a "Donchian channel". A Donchian channel simply tracks the highest high and the lowest low of a lookback period. It wouldn't be any surprise that overbought/oversold readings on the stochastic would be accompanied by "touches" of the Donchian channel. Simply stated, both indicators are telling us when we're moving outside the range designated by the lookback period!

If you choose to use indicators, make sure you know them inside out. What are they helping you "see"? What is their strength, and what is their weakness?

By learning your indicators inside out, you'll gain much more insight than by simply overlaying them on the chart and "trusting them blindly".

What's Next?

In this article, we revisited five common trading mistakes and offered some easy solutions to fix them. Trading from the retail angle requires clarity of mind. It pays to keep the analysis process simple.

You can keep your trading logical and gain peace of mind when making decisions in the markets by: