Aspects Of Behavioural Psychology In Trading
One area that is often over looked especially with new traders entering the market is the psychology that is involved in trading, in particular the psychology of behavior. This pertains not only to individual traders, but also to the market and the collective trading environment as a whole. When you mention the term trading psychology many associate it with the stigma and impact of emotional responses and nothing else.
In truth, the subject delves far deeper into the psyche of each and every one of us, our actions, our responses and our interpretation of information. In this article we will look at some of the areas of behavioral psychology that can be most damaging to a trader, and how we can overcome these characteristics to improve our trading.
Whilst very beneficial in many aspects of our lives over optimism can however be very dangerous in the trading environment. Over optimism is the result of two main reasons, the illusion of control and the self-attribution bias.
The illusion of control refers to where people feel in control of a situation far more often than they actually are. Self-attribution bias refers to the tendency for people to attribute positive outcomes to their own skill and negative outcomes to bad luck. These issues are common among many traders, in particular technical and pattern traders when they attribute profits to their technical analysis and put losses down to unforeseen events. This can be very dangerous and increases the likelihood that traders won’t learn from their mistakes.
Another issue prevalent amongst new traders is when initial trading success without a plan leads to more trading of a similar fashion and overconfidence in trading. This problem is common especially when traders attribute random outcomes to skill, an issue known as ‘random reinforcement’. It is important not to confuse randomness with positive expectancy and recognize that almost any technical indicator will work some of the time, in the process acknowledging that a few winning trades is not the same as long term statistical validation.
Traders can counter aspects of over optimism by creating a professional trading plan. Regular self and peer reviews against the plan will help you evaluate your performance objectively, in the process reducing your propensity to fall victim to random reinforcement and selective memories.
Over confidence is closely related to over optimism and refers to the issue where traders believe they will be correct far more often than they are in reality. A number of biases can cause over confidence.
The Hindsight Bias
The Hindsight bias refers to the tendency for people after the fact to believe that they had predicted the outcome beforehand. This is commonly seen in many aspects of life and not just trading. I’m sure many readers can think of examples such as extreme market tops when people who had been bullish at the top say after the subsequent fall ‘oh the market was in a bubble, anyone could see the crash coming’. Statements such as this are good examples of the hindsight bias.
Confirmation bias refers to the tendency for people to look only for information supporting their view. This issue is very relevant when conducting back testing as it often leads to people thinking their views are more valid than they actually are (known as the illusion of validity). The illusion of validity is prone to occurring when we as traders look for confirming rather than disconfirming evidence.
Another issue we need to be wary of as traders is the survivorship bias. When we are presented with the great results of a few and don’t hear about the many people who have lost large amounts money we are subjected to the survivorship bias. This is a common practice amongst spruikers of black box systems when advertising the results of their system, and should serve to make us extremely weary of their claims.
Over Confidence Summary
Below are some points to consider in your trading with respect to the points discussed above.
- Look for disconfirming evidence before entering a trade. Seek out the reasoning to why others may hold alternative views.
- Remember that events in the market follow an improbable script and rarely adhere exactly to your expectations and point of view.
- Never be 100% sure about anything. The market might arrive at your level but will probably do so in a fashion that you didn’t expect.
- Be very aware of testimonials and adverts for black box packages and courses, which play on the confirmation bias.
Equity Curve Analysis and the Illusion of Control
One way we can address the illusion of control problem mentioned earlier during the discussion on over optimism is by practicing Equity Curve Analysis (ECA). ECA starts with the tracking of results of a system to determine when the system is in and out of sync with the market. By tracking system performance we are able to alter the amount of capital dedicated to the system depending on the performance of the system in the marketplace. Good systems will have clusters of winners and losers rather than a random dispersion of positive and negative results allowing us to easily increase and decrease system capital allocation when its is in and out of sync with the market. When the system is completely out of the market traders will keep a hypothetical running equity curve so as to be able to see when the system is back in sync with the market and hence reallocate capital to the market.
Equity Curve Analysis is a good way to avoid the dangers associated with back testing such as curve fitting whereby traders will continually tweak the system to encompass new data giving a trader a false overconfidence in the system whilst at the same time reducing the systems robustness to changing market conditions.
(For a more complete discussion on Equity Curve Analysis traders are encouraged to visit the March/April/May 2012 issues of tradersonline-mag.com).
Availability Bias, Framing and Prospect Theory
Psychologists Tversky and Kahnemann found that people assess the frequency or probability of an event by the ease of which we can think of examples. This can cause us to be biased when placing a probability on an event outcome as we base this probability on our own experience. The decision is also likely to be influenced by the framework within which the situation was presented.
Tversky and Kahnemann developed Prospect Theory, which is one of the most quoted and best-documented phenomenon’s in economic psychology. Prospect Theory asserts that people are far less willing to gamble with profits than with losses. Research suggests that his happens because we find it hard to cope with a loss and so we will do anything to avoid them. This practice is known as ‘Loss Aversion’.
In another study by researchers Shefin and Statman, it was argued that people are predisposed to holding losers and selling winners. Selling profitable positions leads to happy feelings, meaning people tend to sell winners. Shefin and Statman called this phenomenon the ‘disposition effect’.
One final area I would like to discuss is known as the Status Quo Bias. This is where the psychological benefits of doing nothing and avoiding a loss are so strong that we freeze and take no action at all. An interesting study in the May 2012 edition of the Traders online magazine by a major retail forex provider researched thousands of traders. The study showed that despite an average profitability ratio of 60% most traders were struggling with long-term profitability. Despite the solid profitability ratio, traders typically displayed an inability to manage their capital properly through bad risk/reward ratios. This is almost certainly a result of loss aversion as traders give themselves wide stop losses to minimize the chance of getting stopped. Interestingly the study revealed an average risk reward ratio of 0.55 meaning that the average gains were equal to only ~182% of average losses, less than the 1:3 (300%) ratio we hear so many people talk about.
An understanding of behavioral psychology will help us successfully confront our biases, biases that can reduce our trading potency. Below is a list of pointers to consider when we enter our next trade.
- Always put a stop loss in the system.
- Think about the risk reward ratio you are planning for; is it realistic or a pipe dream?
- Do you think you have a similar trade on to everyone else? If so maybe it’s best not to do it.
- Is the trade unrealistic or poorly thought out? Have you placed an objective assessment on the probability of the favorable outcome?
- A high risk/reward ratio will impact negatively on our profitability rate. We also need to be realistic about our risk/reward ratios as a larger take profit relative to our stop loss will increase the probability of being stopped out of a position. Trailing stop losses are a good way to address this issue.
- We need to have adequate stop losses. A 1:20 risk/reward ratio on a trade may sound like a great ratio but you are unlikely to get the next large move if you’ve only got a 5-pip stop loss. I like to think about it this way, why would we risk such a small amount of capital on a trade if we were confident of a bigger picture move in our favor?
- Trending markets will favor a lower risk reward ratio, as opposed to range trading markets, which typically favor larger risk/reward target ratios.
- Always put take profits and stop losses in the system at the time of making the trade. The latter is more important, as traders may wish to run profitable trades. We should avoid thinking that we will watch a trade and cut it when it looks bad. This will result in loss aversion, as it will be easier on our emotions to let the position run and hope for the best, further averaging into the position leading to disastrous circumstances.
- Think about how you frame your loss, instead of thinking about it as a result of incompetence or that you’re a loser, think about it in the framework that it’s a good learning opportunity, and good feedback.
Any questions or thoughts you have about this post, feel free to leave a comment. Also take a look at our extensive video section for more about how to trade forex and help on how to use the MahiFX platform.