COMMON TRADING BIASES
A bias is best defined by Evans Dylan in the book Risk Intelligence as a tendency to make mistakes of a particular kind, not random errors but ones that are skewed in one direction. In the financial markets, traders often end up on the wrong side of the market due to bad trading habits that are cultivated over time. Traders are humans, they therefore go through biases. In this section, we go through some of the common biases that traders go through:
CONFIRMATION BIAS
In the markets, traders trade their beliefs about markets. It is therefore normal for traders to form opinions after observing the charts and reading patterns. A trader executes a trade after forming hypotheses about the markets; the markets either go his way, making the trade a winner, or the opposite, resulting in a loser. The problem arises when upon execution the trader only looks for information that supports his idea. This results in locking out information that is contradicting, which is more important when trading the financial markets. In the markets, mental flexibility is underrated by most traders while it could be the best way to learn how to cut losses early and to ride winners. A flexible mind will not hold on to trades only looking for information to support it; instead, it will focus on looking for contrary evidence, which could make you realize you were wrong. The solution to this bias is to form an open mind upon execution, knowing that the trade could move in any direction and always be keen to look at every tick of the market and what that means.
RECENCY BIAS
Our brains are constantly receiving new information and experiences. Scientific research has proven that our brains put more weight on recent information than on preceding information. Traders have strings of losses and strings of wins in their trades. A string of wins will often result in overconfidence and complacency among traders, resulting in over trading and over position sizing, which is dangerous for traders. A string of losses will also result in fear of taking opportunities in the markets. The solution to recency bias is using reverse psychology. This means that you should remain calm and focused, no matter what is going on in your trading. When you have a winning streak, you can perceive it as a losing streak which will help you focus and remain calm, avoiding euphoria. Behaviors in the markets are very important, and it is important for you as a trader to master your behaviors.
LOSS AVERSION
No one loves losing. We all want to be winners. Our emotional brain is wired to avoid losses. It is this tendency to avoid losses that will cause traders to execute trades, and if the trade is a winner, the trader will cut the profits early only to satisfy his emotions. The same trader will also do the reverse of holding losing trades for long in the hope of the markets going back, instead of cutting them early. The true test of a trader is how he handles losses and wins. Truly in trading, “if you bring in normal human tendencies toward trading, then you will gravitate toward the majority and invariably lose.”