Understanding Common Psychological Trading Mistakes

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common psychological trading

Common Psychological Trading Mistakes : The Trader has to be the amalgamation of so many skills. Since the stakes surrounding her career are high, so are the expectations. Naturally, you would expect her to be fully adept at assessing a company’s fundamentals. Or to be capable of projecting correctly the trend direction of a stock. But the Trader’s mindset is literally head and shoulders above such technical concerns. 

In the markets, the Trader has to be aware of two basic emotions that can potentially marr her career – greed, and fear. 

In her day-to-day trading occupation, the Trader may be perfect at taking really quick decisions. After all, opening and closing deals can brook no delay. And this has to be in sync with the trading plan as well.

However, it is when confronted with hitherto unknown situations that the Trader can prove her mettle. 

FOMO (Fear of Losing Out)

Sometimes, it might be necessary to think out-of-the-box, overriding the trading plan. Some traders are seriously lacking in confidence in their own trading plan. FOMO happens when the Trader is afraid there will be an abrupt halt to her winning streak. She cannot let go as she thinks she will not get such a streak again. Rather than have faith in her trading plan, the Trader thinks of potential losses once the particular trade in question recedes. 

Rather than count her blessings, she surrenders to counting her losses in the future (which looks all doom and gloom). 

The Trader might go in too early into a trade, or exit too late. Her cognitive biases could really do her in. 

Post Trade FOMO 

The Trader misjudges when to enter the trade following the rally’s start. Entering in the middle price range is liable to make our Trader more of an easy prey to drawdown. Substantial drawdown retracements combined with a plummeting Return/Risk Ratio, would likely result from her having permitted a wide stop loss position. 

Revenge Trading 

Revenge trading happens when the Trader suffers a considerable loss. Doubtless, the debacle was a consequence of wrong assessments. If not, perhaps the causes of the disaster were actually out of her control. Be that as it may, when the Trader succumbs to Revenge Trading, her career goes careening downhill. 

Revenge Trading happens when traders refuse to back away from the scene. Having sustained losses, they think they can get even with the market. They continue trading when they should exit immediately. When the Trader is in great pain, she ought to desist from faulty decision-making. That’s akin to running a marathon with a considerable sprain. 

Further Approaches to Forex Trading Psychology 

Apart from a debilitating lack of self-esteem, there’s also the direct opposite that’s obtainable. Namely, an overweening self-confidence that flies in the face of the market. 

Our Trader must not surrender to feelings of greed or fear when trading, as it can lead to expensive debacles. The Trader should be self-aware if she is liable to succumb to the following: 

  • Overconfidence bias; 
  • Confirmation bias; 
  • Anchoring bias; 
  • Loss bias. 

What is obvious, is that these all have their roots in Fear. 

We will touch upon overconfidence again, in our discussion about mindful awareness in Forex trading below. 

Bridging the lacunae in Cognitive Reasoning – Mindfulness in Trading 

Reading is inherently risky. Our Trader, in her state of Hubris, may well ignore the unknowable nature of the Market. However, when the scales of Probability are ranged too weightily against her, then she will have little choice but to accept defeat. The correct response to abrupt market changes is judicious and measured, rather than anything remotely ‘knee-jerk’. 

Before Mindfulness, there’s Mindlessness 

Reverting to the theme of ‘Overconfidence Bias’ in the Trader – we know that in that state, she is apt to have a skewed perception of reality. She discounts as rubbish what she does not understand. Before coming into the Market to trade, she had had evolutionary behavioural training. This taught her to feed the need for control. 

Biases Reinforced Manifold 

Objective Science teaches us that the need for control arises from the more primitive instinctual mind, where one must respond to threats with a fight/flight response. A trader enters trading, with – as in most professions – a winning attitude. Our Trader is dead certain she’s right -always. That is in objective reality just a prejudice confirmed with a selection of affirming experiences. 

The ‘Illusion of Control’ 

The Market can always teach the Trader thing – or two. She thinks she has the power to control the outcome. This illusion of control, reinforced by experiences that have been ‘kin’ to the learner, breeds overconfidence. Our Trader enjoys putting herself to the test – but the Market, with objective Laws governing it, is bigger than her. 

As per a 2002 study by Biais, Hilton, Pouget, and Mazurier, Overestimation of the accuracy of one’s beliefs is likely to be related to a proclivity to make light of the extent to which a given situation is uncertain and risky. More overconfident subjects following more aggressive trading strategies, suffer from the winner’s curse and can correspondingly earn lower trading profits. Overconfidence has also been shown to be reinforced through biased learning (Gervais and Odean, 2001). Odean (with Barber in the early noughties) has shown several times that overconfidence causes investors to trade more than would be good for them (Odean, 1998, 1999, 2000, 2001).

Traders like this keep deluding themselves until the Market whacks them. In objective reality, our Trader has neither traction nor control. Her overconfident self rather slides, skids, ad slips in the face of Volatility and sundry features of the Unknowable, Uncertain Market. 

Fear-based traders have a different belief-set that’s, however, similarly comprehensible. 

A Rational emotive Approach 

When she enters the Market initially, the Trader has had all her instinctual fight/flight emotional responses to ‘threats to her survival’ hardwired into her. Of necessity, she must always be in the right. This cognitive bias also enables Revenge Trading. To further reinforce her self-image, the Trader eschews all humility and takes her fury out on the Market that has wronged her. 

The Rational Emotive Angle 

A Rational Emotive Approach would use emotions as pointers to the determining features of an event, but allow the final assessment open only for rational, logical thought.  it is more than possible to incorporate the emotional brain into the conscious thinking brain. Our Trader can achieve this with Mindful Awareness. 

Emotions hijacking Rational Thought 

The brain has evolved to seek certainty and control over the outcome. In the process, it even had to lie to itself. When you push your agenda onto the Market, the need to be right is the input from the emotional brain. This is hardwired so that no change can be affected in this. The thinking brain cooks up a narrative to support what the emotional brain has already decided. 

When the Trader rationalises her cherished self-reinforcing beliefs, she is merely rationalising superstitions. the infamous Confirmation Bias has cropped up right here. 

Instinctual Thinking and Flawed Decision-Making

The Trader succumbs to instinctual thinking, which is basically emotional, and outside of the purview of conscious awareness. Prospects of winning and losing are triggers that elicit a knee jerk reaction. Survival response kicks in, resulting in flawed decision-making. Volatility – and suchlike – usher in new rules. The overconfident ( or even timid ) Trader shows her mindlessness. She is unable to put up a coherent response to the Market’s challenge. 

The Uncertain Market only now and ten condescends to tally with traders’ predictions. 

The Community of the Mind and the Probability Mind

Our Trader, considering that her perception is not in sync with objective Reality, has to train herself. This would enable her to have the best of both worlds – emotional and rational. The initial inputs will trigger a fight/flight response. This would subsequently be tempered by Rationality and Logic. Out of the cacophony of voices that issue from the Mind, the Trader must, in a blink, sort out relevant from irrelevant. If a conflict shows you are of two minds, the moment you sort out the ambiguity, you have bought your ticket out of impulsive trading. 

Mindful Trading 

The Trader has to give up Certainty-focus; rather, Probability Management must be her topmost priority while in the Market. She must become used to Uncertainty and Probability. Mindful Awareness, and resultant Mindful Trading, will elevate her consciousness to the point that she can, at any given point in time, make out and use discordant voices emanating from the Mind; use this Insight to reorganise her Trading Mind (in other words, her Probability Mind). 

Gambling Biases in Forex Trading

As the moniker implies, biases derived from gambling have an injurious effect on our Trader, should she become guilty of lazy thinking. The phenomena falling under this category are – 

  • The Hot hand, 
  • The Gambler’s Fallacy, 
  • The House Money Effect, and 
  • Preference Reversal. 

The Hot Hand – In the trading context, the hot hand bias would imply that the Trader would expect herself to make a profit with a new trading decision, once previous investments had paid off. Here, the Trader would be very sanguine regarding her own judgment of trading decisions. Conversely, in the event of the Trader with faith in stock of luck, she will expect to lose money with a new investment if the previous investments had been profitable. Therefore she will desist from investing in new risky choices, post successful investment streak. 

As per Shefrin and Statman (1985), investors take more time to realise their losses and less time to realise their wins. Odean (1998) has found that investors are reluctant to realise their losses. 

The Gambler’s Fallacy 

In our context, traders tend to believe that stagnation is the order of the day in the case of the asset that has made good profits in the past. Following a long period of profit-making, there can be no more profitability. A direct example is the premature selling of stocks. 

The House Money Effect 

When traders gain profits from investments made with their own capital, they do not see the profits as their own money. They consequently willingly take more risks. 

Preference Reversal 

In this context, our Trader, when faced with the choice of two assets will opt for the asset with the lower expected value, but higher probable gain. Traders are sometimes liable to take illogical risks in case higher possible gains being at stake. As per a study by Tversky, Slovic, and Kahneman, long shot overpricing is best understood as an effect of scale compatibility – the prices and the pay-offs being expressed in the same units, pay-offs are weighted more heavily in pricing relative to choice. The possible winnings are perceived as more significant vis a vis probability. 

Normalcy is – Staying Flexible 

Our Trader has to remain flexible, even mull experimentation from time to time. She might examine the possibility of using options as a risk management instrument. She should be open to experimentation. Exposure to newer scenarios -even simulated exposure – is bound to be beneficial. This will lead to a maturer outlook. She should know emotions when she sees them. Rather than be controlled, she should rein in the emotional mind to build up her trading mind. That would give her the best possible control over the Unknown that characterises Probability in the Market. Much easier is the periodic reassessing of the technical skill-set. 

Conclusion

Common psychological trading mistakes can afflict our Trader if she is relatively inexperienced, or has her priorities in less than complete order. Mistakes stemming from cognitive biases are easy enough to overcome – provided your strategy to deal with them is apposite. Mindful awareness techniques have long since lost the narrow confines of mental hospitals, and find plentiful use in everyday life. With a refreshed knowledge of Forex trading, our Trader can re-enter the scene – rejuvenated to take on the (trading) day. 

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