I HAVE BEEN pondering why forex trading is different from nearly every endeavour in life lately. It turns out that humans do very well with the status quo. They like conventions. Back in the day of the caveman, I suppose, conventions and status quos kept you safe. It meant that what had been safely done before could be done again.
That’s true in forex trading too…BUT!
That means that you have to find a convention, or trading plan, that allows you to profit. How is that different from nearly every endeavour, you may ask? Simple – trading is about surfing the waves of price. No two waves are the same. The plan MUST account for that.
In short, the trading plan must be able to adapt to market conditions.
I found this interesting introductory website that talks about trading biases, and was surprised to find myself agreeing with a lot of it. I have rearranged and reinterpreted that information in a way that is more practical for traders, but I do like the original observations. I am presenting them in pairs here, classified according to area of trading. These “secrets hidden in plain sight” are very logical observations that intelligent people in other areas of life surprisingly often fail to see in trading.
Reading Price Action
The ANCHORING BIAS occurs when traders become too conditioned after a long trend, and keep hopping on expecting it to continue. The opposite to this is the CONSERVATIVISM BIAS, which is the tendency to expect the trend to end, and thus miss a long trend.
“OBVIOUS” SECRET!: In the end, no one knows for sure when the trend will end. That’s why you must have an objective way to determine “trend” in the context of your system. It doesn’t matter what it is, in a sense, as long as you stick to it, since this keeps you away from “thinking” excessively about a trade and focussed completely on what price action is saying relative to your trading plan.
Pulling the Trigger
I like to say that there are fear-based and greed-based traders. In technical language, this is the fight between the STATUS QUO BIAS and the OPTIMISM BIAS.
Status quo people get comfortable with a certain level of loss and gain, or worse, with the relatively stability of their account. This makes them fearful when it comes to taking a trade, because that could cause their account to go down. As a result, they miss trades, or risk too little per trade.
Optimists, on the other hand, conveniently forget the risks, so focussed are they on the upside of their trading. This causes them to take excessive risk, and indeed, people prone to this bias often blow their accounts up several times before learning how to trade properly (if they get there).
“OBVIOUS” SECRET!: Both biases can affect a person at any given time, but by and large people seem to prefer one over the other. That is why trading plans have risk-management rules in order to limit both status quo and optimism biases. How much risk per trade? How many losses per day before you call it a day? What is the maximum loss permissible for the month? Answer these questions and work them into your trading plan.
Developing a Trading Plan
The two biases associated with these are the HINDSIGHT BIAS and the CONFIRMATION BIAS. They do not oppose each other, but lead to many dangers in developing a trading plan. The former affects forward testing and the latter affects backtesting.
The CONFIRMATION BIAS refers to the trader subconsciously looking for evidence that a given strategy works. This is regularly manipulated by forex scam artists calling themselves “gurus”. They blithely pick charts which confirm the “strategies” they are teaching, convincing unsuspecting learners that something which doesn’t work at all is marvelous. Forex traders of all levels have to be careful of this – it is easy to see what we want to see, especially in backtesting.
“OBVIOUS” SECRET!: In backtesting, specify the conditions so clearly that anyone can agree on whether or not they were met. Then, scroll the charts in such a way that you cannot see what happens next, and are forced to rely on the rules. This will eliminate most of the confirmation bias.
The HINDSIGHT BIAS adds overconfidence to this volatile mix. This happens largely in forward testing, despite its name. We find a pet theory, and then start to apply it to real markets, theorising as to what will happen next. When we are right, we are jubilant. When we are wrong, we conveniently forget it. This hindsight bias is lethal, because we are then tempted to put money on methods that are nowhere near as good as we thought they were.
“OBVIOUS” SECRET!: If you think you are on to something, write it down. Keep a strict trade log of what you are looking at and why, and note the results afterwards. This simple technique will “keep it real”. Alternatively, open a very small account and trade the system in pennies. That will allow you to see your performance in actual terms. Simple, isn’t it?
Staying in the Trade
There are two biases which pull in opposite directions here – the REGRET AVERSION BIAS tempts the trader to hang onto losers, hoping to avoid the intense regret when a trade goes in his favour. On the other hand, having gotten into a trade, the LOSS AVERSION BIAS screams at the trader to get out because the market isn’t going in his direction, and he subsequently fails to ride the move to the end.
“OBVIOUS” SECRET!: It really is obvious – the trading plan must have provisions to trail a stop in the case of a winning trade, forcing the trader to stay in. On the other hand, stop loss and emergency exit conditions must be strictly adhered to. For newer traders who dislike the pain of staying in a trade, I recommend having two positions – one that is based on a target and another that can be trailed. That way, you have the best of both worlds!
With best wishes for your trading,
Private Fund Trader/Head Trader Consultant
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