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Contents

Simple Hacks On How To Improve Your Trading Psychology

One of the most important aspects in any trader or investors journey is trading psychology. If you have been trading for any length of time, you’ll more than likely have experienced the highest of highs and lowest of lows.

But is this conjusive of good trading behavior ?

Trading psychology is a massive part of your success in trading and investing, yet so many people pay little to no attention to it. Why ? Because very few recognize the significance of it.

What exactly am I talking about ?

Well, have you ever entered into a trade only for it to go against you straight away and stop you out ? And then get angry when it immediately goes in the direction you initially figured it would do ?

Now imagine this happens a couple of times, you start to get angry and revenge trade. This is trading psychology 101 causing you to make dumb decisions based solely off your emotions.

Don’t be too hard on yourself, we have all done it and it can occasionally slip in even with veteran successful traders and investors.

So how on earth can we fix this ?

Well, first things first, we must identify it is a problem. A lot of people aren’t willing to accept it, therefore everything they do is wrong. But once you figured out your issues, you can work on fixing them.

*Before we get started, I am in no way a specialist or have any skills in psychology, I am simply outlining what has happened to me on my journey and how I continue to improve the issues we all face as traders.

What are the main components of trading psychology ?

Simply put, in terms of trading, your psychology framework is made up of 4 parts. Fear, Greed, Hope & Anger.

Have you ever wondered why if you give 4 traders the exact same trading strategy, there will be 4 different results ?

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Look at the turtle trader experiment. They all traded the same strategy yet were widely different in their overall returns.

Simply put, our psychological profile.

If we are honest, most of us have experienced some if not all of these emotions outlined above at some stage in our trading journeys. When I started out, I think I would experience all of these emotions in a given day but that’s another story ��

Here is an absolutely great tweet by millionaire trader Mark Minervini.

So let’s dive into the individual parts of our psychology in trading.

1.Fear

Picture this. You see a stock breaking out and you missed your initial entry. What do you end up doing ? You chase that entry because you just don’t want to miss the move.

If we are honest, we have all done this. Fear of missing out (FOMO) is one of the most deadly aspects of your psychology that can really play havoc to your underlying returns.

If you have a valid strategy, chasing trades can really effect the end results. Even a few cents difference in the price you enter can skew risk and reward and over time this will take away profits.

And who want’s to earn less ?

Obviously no one.

Imagine you change the question around to something more basic.

Ask yourself, Would I like to give away some of my profits due to chasing trades ?

You see when you look at it this simple, this is exactly what we are doing. When we trade based off FOMO, we are essentially saying, yes we would like to give away some profits chasing trades.

That’s obviously a very basic understanding but us humans are very emotional beings (some more than others) no matter how hard we try.

Trading Psychology Tips To Improve Fear Issues

Once you can accept you have this issue, what can we do to improve it ? Don’t be too hard on yourself at the start. It takes time to essentially rewire your brain. You’ve identified the problem. Looked at your stats and realized that FOMO is causing you to lose X amount of dollars on average per trade.

So now, armed with hard statistics that cannot be denied, you can go about sorting yourself out.

There is no magic pill or solution. Just hard work. In my own stats early on, I figured out I was leaking 1% of trading profits on FOMO. This was either because I skewed my risk reward to much and that affected my underlying returns or I would just be pissed off I missed an entry and chase it to death.

Some of you might be thinking, 1% is nothing. But TRUST ME, over the course of a year, this adds up massively. So much so that it could be the difference between a profitable and losing trader.

The most simple changes usually can have the biggest changes. Instead of chasing an entry I may have missed. I set up all the alerts for setups I wanted. It’s embarrassing to think I hadn’t done this prior but I was new and needed to make these mistakes to learn.

I swore to myself that if I didn’t get the price I wanted, so what ! There are plenty more opportunities out there.

Sure ! I’d have missed out on some big winners but the overall returns were much much better from this one adjustment. When you really know your statistics inside and out, making these psychological changes in trading becomes a lot easier.

When we trade based off FOMO, we are essentially telling ourselves, yes market, I don’t wan to make as much profit as long as I get this entry.

We can’t argue with our stats, it’s right there in front of us so yes, it really is that simple. We don’t want to make as much.

2.Greed

You are in a trade and are up nicely and almost at the area you plan on taking your profits. But then you decide, I’ll move my profit point even more. Then the price hits your original planned area and then retraces.

Even writing this, I recall times this happened to me and made my blood boil.

How could I be so stupid I think to myself

Well, this is greed is full swing. Annoyingly, this too was a common early trait in my trading career that needed to be ironed out.

Again, I looked at the maths. It was losing me money in the long run and I always simply asked myself, do i want to make less money by doing this ?

I flipped greed on it’s head and reversed it. Instead of wanting to make more money by moving targets, i was actually losing more money long term so now I just stuck to my pre made plan and took it from there.

If I moved my targets while in a trade for no reason, I simply said to myself, okay I’m accepting I want to make less money overall by doing this.

Don’t get me wrong, there are times when you will need to make take profit adjustments depending on your strategy, e.g a new announcement in a stock you’re holding causing an unexpected move in the price.

You may notice a pattern by now, my absolute reliance on my statistics to make decisions.

It’s soooo important you keep a trading journal. You need to know all there is about yourself. Otherwise, you won’t know what changes to make.

3. Hope

Ah yes, my good old friend hope. There have been times when I questioned my own sanity and hoped for trades to come back after I left it get out of hand. I would say I made every mistake in the book when I started the this was another psychological issue that needed to be addressed.

Don’t believe me, just look at my trading story . Tough times to overcome indeed !

Hope is another dangerous thing in the world of trading. Why ? Because you can really screw yourself over.

How many times have you been in a trade that got out of hand and found yourself hoping it would come back to your original planned stop area or breakeven point?

If you are honest with yourself, probably a lot. I know I did this a lot.

How can this be fixed ?

Again, it all boils down to your statistics. I might sound like a broken record constantly referring to my trading stats but it really is that important.

So how much is my good friend hope making me ? Well, no surprise, zero ! So why continue this relationship I thought. She had a good hold on me but after reviewing over and over again, i realized I had to let her go. One of my tougher break ups it must be said ��

4. Anger

Finally, anger. Probably the most destructive of all trading psychology issues I faced. I’m embarrassed to say it but my anger did get the better of me at the start.

One too many keyboards suffered as a result of my anger at a particular trade.

So what happened ?

Picture the scenario. You enter a trade, get stopped out. Enter another trade and get stopped out. Try this 10 times in a row. Obviously, you are going to get angry. it’s human nature.

So how can you fix this ?

I joke but you guessed it, diving into my trading statistics helped me realized that it wasn’t making me any money. Sounds common but as Ed Seykota said.

“Everyone gets what they want out of the market”

Can you see what he means now ?

If we are angry and start revenge trading, we get what we want and that is revenge. Unfortunately this usually comes at a price, usually a very costly one.

Trading Psychology Of Successful Traders

Right, now we know what not to do. What do the good traders do ? Well, they focus on always improving. Standing still in this game is really going backwards and we don’t want that.

To summarize this. Top discretionary traders have common traits that they learned the hard way.

  • Discipline to trust and follow their trading plans
  • Understanding their psychological weaknesses and tackling them head on
  • Constantly improving through learning and tweaking
  • Ability to analyze themselves with no bias.

Every part of the psychological framework would not be fixed without absolute control and discipline. It is very tough to simply say, follow your statistics and don’t be greedy or fearful.

But it is one of the challenging parts of trading that needs to be fixed.

Obviously you sometimes might not be able to do this alone. And that is okay. There are some great educational resources to help guide you in the right direction.

So where can you get started with finding help ?

Trading Psychology Course

Don’t worry, I’m not trying to sell you some course I have an affiliation with. On the contrary. I’m simply outlining some places that helped me on my journey. First up, we need to outline the best and most well known trading psychology coaches out there today.

  • Van Tharp
  • Brett Steenbarger
  • Mark Douglas
  • Dr. Alexander Elder

There are tons more but these are the most well known and common. Some offer great workshops and courses to help improve. When I was working in a prop firm, we regularly had sessions with trading psychologists (not the ones outlined above) but it is obviously important.

Van Tharp

Van Tharp has a great trader test where if you can answer it without bias, you will receive a report through email on what type of trader you are and a comparison to a successful trader or investor who has similar traits

This report offers areas you need to focus on going forward so this can be helpful. Again, the tricky part is answering this test honestly. Otherwise, you won’t get accurate results.

Here’s a video of Van Tharp teaching . The quality isn’t great but its the best I could find.

Tharp also has a few books where you can learn from him if you couldn’t afford to attend a workshop he does. Keep in mind that in the list of workshops on his site, they are not all delivered by him.

Brett Steenbarger

Another really great guy for learning how to work on your trading psychology is Brett. He has many great posts about it to help guide you in the right direction.

Here is a great webinar to help gain insight into the man and what he has to offer.

Trading Psychology Books

There are lots of trading books out there tailored to addressing your psychological issues. My favorites are :

  • Super Trader By Van Tharp
  • Trading in the zone by Mark Douglas
  • Trading For A Living by Alex Elder
  • The Daily Trading Coach By Brett Steenbarger

Again, you might have your own preferences but these we very helpful trading books for me.

Conclusion

I could go on and on with what all these different coaches have to offer but honestly, it is down to your own preference. Some people will say that you don’t need help with psychology. I personally believe you do. Well, I did ! Maybe you can overcome your issues and that’s great if you can go it alone but I preferred to get a helping hand along the way.

It doesn’t matter if you want day trading psychology tips or long term investor psychology tips, it is all the same. As long as you are human, we all suffer the same re occurring issues all the time, it doesn’t matter what style of trading you do.

Fear, Greed, Hope & Anger are very real issues that need to be addressed. The best way of dealing with them as we have seen is through discipline. The trading coaches mentioned offer help in improving this too and the books can be very useful in guiding you on the right path.

The very best of luck in your trading and I hope you all get the discipline you deserve !

A Guide to Trading Psychology

Trading Psychology: Beyond the Basics

The psychology of trading is often overlooked but forms a crucial part of a professional trader’s skillset. DailyFX is the perfect place to learn how to manage your emotions and hone your trading psychology; our analysts have already experienced the ups and downs, so you don’t have to.

Keep reading to discover their top tips, and to learn more about:

  • What is trading psychology
  • How to get in the mindset of a successful trader
  • The basics of trading psychology
  • Trading psychology tools and techniques

Learn more about the realities of trading in our ‘ Day in the Life of a Trader ’ videos.

Unsure of what trading style to employ? Discover your niche with our DNA FX Quiz !

What is Trading Psychology?

Trading psychology is a broad term that includes all the emotions and feelings that a typical trader will encounter when trading. Some of these emotions are helpful and should be embraced while others like fear, greed , nervousness and anxiety should be contained. The psychology of trading is complex and takes time to fully master.

In reality, many traders experience the negative effects of trading psychology more than the positive aspects. Instances of this can appear in the form of closing losing trades prematurely, as the fear of loss gets too much, or simply doubling down on losing positions when the fear of realizing a loss turns to greed.

One of the most treacherous emotions prevalent in financial markets is the fear of missing out, or FOMO as it is known. Parabolic rises entice traders to buy after the move has peaked, leading to huge emotional stress when the market reverses and moves in the opposite direction.

Traders that manage to benefit from the positive aspects of psychology, while managing the bad aspects, are better placed to handle the volatility of the financial markets and become a better trader.

The Basics of Trading Psychology

Fear, greed, excitement, overconfidence and nervousness are all typical emotions experienced by traders at some point or another. Managing the emotions of trading can prove to be the difference between growing the account equity or going bust.

Traders need to identify and suppress FOMO as soon as it arises. While this isn’t easy, traders should remember there will always be another trade and should only trade with capital they can afford to lose.

Avoiding trading mistakes

While all traders make mistakes regardless of experience, understanding the logic behind these mistakes may limit the snowball effect of trading impediments. Some of the common trading mistakes include: trading on numerous markets, inconsistent trading sizes and overleveraging.

Greed is one of the most common emotions among traders and therefore, deserves special attention. When greed overpowers logic, traders tend to double down on losing trades or use excessive leverage in order recover previous losses. While it is easier said than done, it is crucial for traders to understand how to control greed when trading .

Importance of consistent trading

New trades often tend to look for opportunities wherever they may appear and get lured into trading many different markets, with little or no regard for the inherent differences in these markets. Without a well thought out strategy that focuses on a handful of markets, traders can expect to see inconsistent results. Learn how to trade consistently .

“Trade according to your strategy, not your feelings” – Peter Hanks , Junior Analyst

Debunking Trading Myths

As individuals we are often influenced by what we hear and trading is no different. There are many rumours around trading such as: traders must have a large account to be successful, or that to be profitable, traders need to win most trades. These trading myths can often become a mental barrier, preventing individuals from trading.

Get clarity on forex trading truths and lies from our analysts.

Implementing risk management

The significance of effective r isk management cannot be overstated. The psychological benefits of risk management are endless. Being able to define the target and stop loss , up front, allows traders to breathe a sigh of relief because they understand how much they are willing to risk in the pursuit of reaching the target. Another aspect of risk management involves position sizing and its psychological benefits:

“ One of the easiest ways to decrease the emotional effect of your trades is to lower your trade size ” – James Stanley , DFX Currency Strategist

How to Get in the Mindset of a Successful Trader

While there are many nuances that contribute to the success of professional traders, there are a few common approaches that traders of all levels can consistently implement within their particular trading strategy .

1) Bring a positive attitude to the markets every day . This may seem obvious, but in reality, keeping a positive attitude when speculating in the forex market is difficult, especially after a run of successive losses. A positive attitude will keep your mind clear of negative thoughts that tend to get in the way of placing new trades.

2) Put aside your ego. Accept that you are going to get trades wrong and that you may even lose more trades than you win. This may seem like all bad news but with discipline and prudent risk management , it is still possible to grow account equity by ensuring average winners outweigh the average losses.

3) Do not trade for the sake of trading. You can only take what the market gives you. Some days you may place fifteen trades and in other instances you may not place a single trade for two weeks. It all depends what is happening in the market and whether trade set ups – that align with your strategy – appear in the market.

“Trade decisions are not binary, long vs short. Sometimes doing nothing is the best trade you can make” – Ilya Spivak , Senior Currency Strategist

4) Do not get despondent. This may seem similar to the first point but actually deals with thoughts of quitting. Many people see trading as a get rich quick scheme when in fact, it is more of a journey of trade after trade. This expectation of instant gratification often leads to frustration and impatience. Remember to stay disciplined and stay the course and view trading as a journey.

Trading Psychology Tools and Techniques

At DailyFX we have a whole library of content dedicated to the psychology in trading. Take some time to work through the following topics:

  • Listen to our podcast on how to create a trading plan
  • Learn how to create and maintain a trading journal
  • Avoid the #1 mistake traders make by adopting the traits of successful traders
  • Setting a stop loss instead of a mental stop loss is a great way to avoid runaway losses.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

Delve inside your mind

How does psychology impact trading? Discover the factors that can influence financial decisions – personality, emotions and moods, biases and social pressures – and hear from experts and traders about the challenges psychology can create.

Click on a factor to explore.

Personality

Personality is the combination of characteristics that make up each trader’s distinct identity. The features of a trader’s personality will predispose them to certain financial behaviours, determine how they will perform and their susceptibility to other psychological influences. Take a look at five key areas of personality: discipline, decisiveness, patience, rationality and confidence.

Social pressures

Social pressures are external factors that can have a direct influence on a trader’s psychology, encouraging them to change their attitudes, values and behaviours. The social pressure to perform in a certain way can cause errors and lead to traders taking on greater amounts of risk. Discover the impact of herding, rumours, news and competition on trader’s behaviour.

Behavioural biases

Behavioural biases are subconscious but systematic ways of thinking that can occur when the brain makes a mental shortcut. Biases can impact the way traders make and implement decisions. Discover six biases that can influence traders: availability bias, anchoring bias, hindsight bias, confirmation bias, loss aversion bias and gambler’s fallacy.

Emotions and moods

Emotions are chemical changes in the nervous system that cause an instant reaction to an event, while moods are a by-product of our emotions that can last for a lot longer. The emotional state of a trader can have a significant influence over the way they react to certain circumstances and triggers. Explore the psychology of fear, greed, hope, frustration and boredom, and the impact they can have on a trader’s performance.

Rationality

What is ‘rationality’ in trading?

Rationality in trading is the ability to make choices that will result in the best possible outcome given the information available. Rational decisions aim to maximise an advantage, while minimising any losses.

Although rationality is all about seeking the optimal outcome, studies have been quick to point out that this doesn’t always mean making money – a rational decision can involve minimising losses and even accepting a loss.1

How can traders become rational?

A common way to improve rational decision-making is through a demo account, which enables you to practise trading and test your strategy without risking any capital.

A demo account can help you to familiarise yourself with market dynamics so that when you start to trade using your own money, you won’t be overwhelmed by feelings of fear – enabling you to trade in a more rational way.

Things to keep in mind.

Fear can cause traders to close positions too early and miss out on profit.

Gambler’s Fallacy

Gamblers’ fallacy can lead to traders basing their decisions on irrational beliefs.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Decisiveness

What does ‘decisiveness’ mean in trading?

Decisiveness in trading is the ability to identify opportunities and act efficiently – this includes making decisions about when to enter and exit trades, assimilating new information into a plan and learning from mistakes.

According IG’s survey, 27% of investors ‘go with their gut’ when making decisions about money. However, research by Gollwitzer showed that ill-informed decisions can lead to excessive risk, because they cause a disparity between a plan and its execution1. Although it is important to act quickly, it is also important to make sure you have taken all the available information into account to give yourself the best chance of making rational decisions.

How can traders become decisive?

The best way to become decisive is to create a suitable trading strategy that outlines what you will need to see in your technical and fundamental analysis before you open a trade. This enables you to identify suitable entry and exit points before you start trading and ensures that your decisions have a solid foundation in historical data and trends, rather than ‘gut feeling’.

If you focus on technical analysis, you’ll use indicators to study signals and trends. The data they give off is then used to establish entry and exit points, and where to place stops and limits. Popular technical analysis tools include Fibonacci retracements, moving averages and Bollinger bands. If you choose to use fundamental analysis you’ll evaluate macroeconomic data, company financial reports and the news to establish how and when to trade.

If you aren’t confident in your ability to stick to your pre-made decisions, you could consider automating your trading strategy. This is where you would set the parameters of your order and allow an algorithm to analyse the market and respond to opportunities as they arise.

Things to keep in mind.

Fear can cause traders to close positions too early and miss out on profit.

Availability Bias

Availability bias can cause traders to act on information that is more accessible than reliable.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Confidence

What is confidence in trading?

Confidence in trading is trust in one’s own abilities and knowledge. Every trader requires a certain level of confidence so that they can identify and act on opportunities, as well as bounce back after a losing streak.

IG’s survey found that investors and traders had higher levels of confidence when it comes to financial decision-making than non-investors. However, there is a difference between confidence and over-confidence, which is an unrealistic view of one’s abilities. Research by Dorn and Huberman found that, of the 1345 German investors they surveyed, those who considered themselves more knowledgeable than average were actually more prone to excessively buy and sell assets1. This habit can lead to further losses and decisions that are based on fear rather than research.

All traders will experience losses, but a confident trader will know that everyone has bad days and that sets them apart is learning how to minimise these losses.

How can traders become confident?

The best way to become a confident trader is by trading using a demo account, which enables you to test your trading strategy in a risk-free environment using virtual funds. Alternatively, you could opt to backtest your trading strategy by taking a chunk of real data from a selection of markets and running your strategy against it.

Both methods enable you to build up confidence in how your strategy would perform, without using any actual capital. However, it’s important to remember that neither provides a perfect reflection of a live market, as they won’t always take factors such as liquidity into account when executing your trades.

To avoid being overconfident, just remember that there is never an end to how much you can learn and the experience you can develop. Even the most successful traders can learn more and develop their strategy further.

Things to keep in mind.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

Rumours

Rumours often cause individuals to trade based on unreliable information.

Loss Aversion Bias

Loss aversion bias can cause traders to let losses run, potentially eroding profits.

Patience

What is ‘patience’ in trading?

Patience is the ability of a trader to wait for signals that indicate that it is time to enter or exit the market. This could include making decisions that delay instant gratification in the hope of a future benefit.

IG’s survey found that 66% of participants trade or invest as they recognise it will provide a better return than cash savings. But if a trader doesn’t have the discipline to stick to their trading plan and the patience to wait for the correct market conditions, it can have a huge impact on their long-term goals.

A study by Freeman-Shor found that only 21% of the stock investments analysed realised a return of over 100%, even though many of the shares went up by significantly more over time1. This was because very few individuals had the patience to wait for the trend to run, preferring to sell for a much smaller profit than risk losing what they had made.

Although it is unreasonable for traders to expect huge returns from every trade, it is important not to ‘snatch profits’ in small amounts out of fear or loss aversion . Although this might give a sense of instant gratification, there is the risk of losing out on a much larger gain.

How can traders become patient?

To develop patience, it is important to understand that your desired market movement might not happen straight away or at all. Building a suitable risk management strategy is a great way of managing impatience – this should include setting stop-losses and limit orders.

For example, a trailing stop-loss will automatically follow your position by a certain amount of points. This enables you to lock in your profit if the market moves in your favour, but it will remain in place if the market falls – closing out your position if the market moves against you.

Things to keep in mind.

The Art of Execution: How the World’s Best Investors Get It Wrong and Still Make Millions, Lee Freeman-Shor (2020)

Greed

Greed can lead to irrational decisions in the pursuit of excessive gains.

Gambler’s Fallacy

Gamblers’ fallacy can lead to traders basing their decisions on irrational beliefs.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Discipline

What does ‘discipline’ mean in trading?

Discipline in trading is the practice of sticking to strategies, avoiding holding onto losing trades and taking profit at the right time. It is an attribute that regulates attention, emotional responses and decision making .

Without discipline, traders risk letting their emotions cloud their judgement, which could lead to large losses. In fact, a study by Lock and Mann found that the median holding time for losses is over four times as long as the holding time for gains1, and this lack of discipline makes a trader less likely to be successful in the future.

How can traders become disciplined?

The best way to become disciplined is by creating a trading plan and outlining a risk-to-reward ratio – this compares the amount of money you are risking to the potential gain to your position. In theory, with the right ratio, you could lose more than you win, and still make a profit. For example, if your ratio was 1:3, you would only need to be successful on three out of ten trades to have an overall profit.

According to IG’s survey, only 55% of investors believe that they are disciplined and will stick to the rules they have outlined for themselves. By sticking to your trading plan and risk management measures, you can reduce the likelihood of being caught out by large losses.

Things to keep in mind.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

Anchoring bias

Anchoring bias can lead traders to rely on an initial piece of information.

Patience

Patience is vital to finding the best trading conditions.

Gambler’s fallacy

How can ‘gambler’s fallacy’ affect traders?

Gambler’s fallacy in trading is the tendency of an individual to think that a trade will go a certain way based on past events – even though there is no substantive evidence to support the trader’s thinking. The term originated from the inclination of gamblers to think that a bet might go a certain way based on previous results.

When applied to trading, a study by Rakesh found that 55% of investors who took part believed that a random event would occur again just because it had occurred in the past1. This could cause a trader to base a decision on previous analysis, even when the indicators which had worked for them in the past are no longer relevant or helpful given the current market movements.

How can traders prevent gambler’s fallacy?

You can minimise the risk of gambler’s fallacy affecting your trading by basing your decisions on up-to-date analysis and setting a clear risk-to-reward ratio – which compares the potential loss to the potential gain for each trade you open. This can help you to think clearly and assess each situation on its own merits, and will also minimise the effects of any losses on the overall value of your trading account.

An example of a risk-to-reward ratio would be if you placed a guaranteed stop on a trade, capping your maximum loss at £100, along with a limit giving you the potential to realise a £300 profit. In this scenario, the risk-to-reward ratio would be 1:3.

With a 1:3 ratio, you could generate a profit by only being right 30% of the time. This is because if you placed ten trades risking a maximum of £100 each, you would lose £700 from your seven losses, but you would make £900 from your three gains. Of course, if you’re taking on less risk for a greater potential reward, it’s likely the market will have to move further in your favour to reach your maximum profit, than it will to hit your maximum loss.

Things to keep in mind.

Confirmation Bias

Confirmation bias causes traders to disregard information that doesn’t match their beliefs.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

Loss aversion bias

How does ‘loss aversion bias’ affect traders?

Loss aversion bias is a preference for avoiding losses over acquiring the equivalent gains. It implies that the fear of a loss is greater than the pleasure of a gain.

Research by Odean looked at 10,000 trading accounts held between 1987 to 1993, and found that individuals have a tendency to hold on to losing positions for a much longer period of time than winning trades, out of a fear of realising a loss.1

Percentage of trades closed at a gain and loss

IG data backs this up, showing that although traders close over 50% of trades at a gain, they lose significantly more on their losing trades than they make on their winning ones. This emphasises that instead of accepting a small loss, many traders will hold on to their positions and risk eroding their profits.2

How can traders prevent loss aversion bias?

A key step in preventing loss aversion bias is acknowledging that it exists. When you start to create a trading plan, it is important to consider how much you are willing to lose as well as how much you want to gain. And once you have established your trading plan, it is important that you have the discipline to stick to it to avoid taking unnecessary losses.

One way of doing this is by setting a suitable risk-to-reward ratio, which compares your capital at risk to the amount you stand to gain. For example, if you set a ratio of 1:3, then you’d only need to profit on three out of ten trades to have an overall profit. The correct risk-to-reward ratio could ensure that your gains are always at least as large as any potential losses, giving you the confidence to overcome loss aversion bias.

Things to keep in mind.

Discipline

Being undisciplined can cause traders to hold on to losses.

Herding

Herding can lead to traders making decisions out of a fear of missing out.

Gambler’s Fallacy

Gamblers’ fallacy can lead to traders basing their decisions on irrational beliefs.

Confirmation bias

How can ‘confirmation bias’ affect traders?

Confirmation bias is the tendency for traders to search for, and put greater weight behind, information that confirms their pre-existing beliefs or predictions. This could mean that a trader disregards negative news about an asset because they believe that the good outweighs the bad – even though this may not be the case.

Confirmation bias is linked to overconfidence, which can lead to poor decision-making and overtrading. A study by Park, Bin Gu, Kumar and Raghunathan found that traders with stronger confirmation bias are likely to exhibit greater levels of overconfidence and trade more frequently. This can lead to them obtaining lower profits because they might lose more often. IG’s survey revealed that 29% of traders and investors go with their gut when making decisions – a sure sign of overconfidence.

How can traders prevent confirmation bias?

Confirmation bias can be prevented by carrying out your own analysis – whether this is technical or fundamental – and trusting that it is correct, even if it clashes with earlier predictions or preconceptions.

Technical and fundamental analysis can be a great way for you to identify whether you should be buying or selling a particular asset – for example, overvalued stocks or undervalued stock. Analysis can confirm the true value of an asset in a more accurate and definitive way when compared to say, preconceived biases or gut feelings.

It could even benefit you to actively seek out information that clashes with your preconceptions because this could counteract your confirmation bias – forcing you to think about each trade in terms of its own merits.

Things to keep in mind.

Confidence

Overconfidence can cause traders to have unrealistic views of their abilities.

Loss Aversion Bias

Loss aversion bias can cause traders to let losses run, potentially eroding profits.

Hindsight Bias

Hindsight bias can make traders falsely confident in their decisions after an outcome is known.

Hindsight bias

How does ‘hindsight bias’ affect traders?

Hindsight bias in trading is the tendency for individuals to express that they ‘knew it all along’, once they know the answer to a question or the outcome of an event that was previously uncertain.

The consequence of hindsight bias is that it often leads to a false sense of confidence . IG’s survey found that up to 55% of traders believe that they are very disciplined when trading – however, this is a dangerous mindset because biases can creep in and lead to irrational trading decisions.

A study by Biais and Weber found that those who exhibited the hindsight bias failed to remember how uncertain they had really been before they made their decisions. This means that they may have been inefficient in making choices regarding risk management. From the 85 investment bankers surveyed, all were found to exhibit hindsight bias.1

How can traders prevent hindsight bias?

One way to minimise the impact of hindsight bias is by keeping a trading diary. A trading diary is used to record your progress, keep track of your trading, and plan and refine your strategies. You should also use it to make a note of how you feel before, during and after each trade. By writing down whether you feel confident, afraid, hopeful or uncertain, you will be better placed to get a sense of when you were successful.

By mapping the reasons behind trading decisions and comparing them to the desired outcomes, you can use your past trades to inform your future strategy. So, instead of trying to make sense of what happened by oversimplifying the reasons for past events, you can learn from the outcome.

Things to keep in mind.

Discipline

Being undisciplined can cause traders to hold on to losses.

Rationality

Rational decision-making is key to minimising losses.

Confidence

Overconfidence can cause traders to have unrealistic views of their abilities.

Anchoring bias

What is anchoring bias in trading?

Anchoring bias is the tendency for traders to allow an initial piece of information to have a disproportionate influence on future decisions, regardless of its relevance.1

For example, research by Kaustia, Alho and Puttonen showed that individual’s estimates of stock returns were significantly influenced by the starting value they were given – the ‘anchor’2. When participants were given a high historical stock return they were more likely to estimate that the future return would also be high, while a group given a lower initial value had far lower estimates.

Anchoring bias can have dangerous consequences in trading, as it might mean that a trader holds on to an asset far longer than they should do, or that they make an inaccurate assessment of an asset’s worth based on the anchor value.

How can traders prevent anchoring bias?

The best way to prevent anchoring bias in trading is by performing comprehensive research and analysis of the market to identify your own anchor.

IG’s study showed that only 28% of traders and investors used personal experience as a source of information. But by doing your own analysis of macroeconomic trends and historical data, you will be better placed to identify key support and resistance levels. It is important to have confidence in your own plan before you look at someone else’s estimates – whether this is an analyst or fellow trader.

Things to keep in mind.

Availability Bias

Availability bias can cause traders to act on information that is more accessible than reliable.

Hope can make it hard for traders to cut their losses and lead to unnecessary risks.

Competition

Competition can cause traders to adopt problematic habits.

Availability bias

How does ‘availability bias’ affect traders?

Availability bias is the tendency to open or close positions based on information that is easily available, rather than sources that are more difficult to find. It can cause traders to act on false or unverified information, which can lead to higher levels of risk and loss.

Traders tend to lean towards what is personally most relevant, recent or emotional, even long after the event is over. The mind can take a shortcut based on examples that come to mind immediately, rather than on research and analysis. For example, if a person has a family member who recently lost money on a bitcoin trade, they may be less inclined to speculate on the cryptocurrency because it is hard for them to imagine that the market can be profitable.

In fact, a study by Moradia, Meshkib and Mostafaei found that there is a strong correlation between judgement and data availability. By surveying investors of stocks listed on the Tehran Stock Exchange, the researchers concluded that decision-making would likely improve as the amount of information released to the public increased.1

How can traders prevent availability bias?

The most common way to prevent availability bias is to conduct extensive research and analysis. Participants of IG’s survey were comfortable using multiple sources to gather information on trading and investing. Although 56% used the internet, some also used newspapers, specialist publications, financial advisers, television and podcasts.

Fundamental analysis is used to examine internal and external factors such as earnings reports, how the sector is performing, and the health of the economy, while technical analysis looks at historic price data and indicators to establish key entry and exit levels for each trade.

If you don’t feel confident enough to trade on live markets, you could test your strategy on a demo account first. This enables you to practise trading with indicators and test your strategy in a risk-free environment using virtual funds.

Things to keep in mind.

Fear can cause traders to close positions too early and miss out on profit.

Decisiveness

Poor decision-making can lead to traders taking on excessive risk.

Trading Psychology

Education and Research

Trading Psychology

Trading psychology refers to the state of mind of traders when they are active in the financial markets and how this affects their trading decisions. This psychological side of trading is often overlooked. A sound state of mind means a trader executes his plan consistently, is mindful of the risks involved, is not hindered by emotions, takes equal responsibility for wins and losses and is realistic about trading in general. Bad trading psychology is one of the top reasons traders fail.

Signs of good psychology include not being emotionally attached to individual trades, not being affected by performance anxiety, focussing on results over a larger number of trades and not putting up positions that are too big to handle. Good psychological traders do not engage in revenge trading, do not second guess trades, and focus on self-improvement without sabotaging their results. They are honest about wins and losses, hold themselves accountable and understand how to deal with fear and greed. Both can be destructive emotions and several techniques exist to control them.

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