In the last chapter, we talked about various emotions that traders face when trading. We discussed how these emotions can influence their decisions and hurt their trading performance. Besides being driven by emotions, traders are also influenced by the inherent biases they possess. Just like emotions, biases can adversely affect the performance of a trader. In this and the next chapter, we will talk about some of the most common biases that traders exhibit when trading and how to overcome these biases.
Humans are exposed to various biases, some of which tend to be conscious and some subconscious. Take the example of driving a vehicle. When you are learning how to drive, you consciously think a lot before making every move. However, once you become proficient at driving and gain a lot of driving experience, you do not tend to think as much when making each move as you did back when you were learning how to drive. Instead, some of the decisions that you now take tend to be subconscious. That is, without you having to think about it. In fact, some degree of subconsciousness would be at play for any activity that you do routinely and have got accustomed to.
Just as it is natural for humans to be inherently biased when making decisions in day to day lives, similarly, it is natural for traders to exhibit some form of biasness when making decisions. Sometimes these biases tend to be subconscious. It is natural to have biases, but if you fail to control them and let them influence your trading decisions, they can hinder your trading success. As an example, you may set a target of doubling you trading capital in the next, say, 5 years. However, to reach there, you will have to take risks. While taking trading risks is not bad and is in fact necessary to earn returns, your mind may subconsciously refrain you from taking risks due to a fear of capital loss. If you let your subconsciousness get the better of you, it might deter you from achieving your trading objective. Hence, it is necessary to ensure that your biases do not influence the trading decisions you make.
Over the remainder of this chapter as well as in the next chapter, we shall talk about some of the common biases that traders exhibit when trading and how to overcome each of these biases.
When you are considering taking a trade or are already in a trade, have you ever been on the lookout of only those information that are supportive of your view while ignoring those that are unsupportive? If yes, you exhibit confirmation bias. Confirmation bias means only considering those information that confirm your existing ideas and actions, while rejecting those that counter your existing ideas and actions.
As an example, let us consider a situation wherein a trader is long a stock. To justify holding on to the long position, the trader could seek out for only bullish data and information that support his position, while filtering out all the bearish information that come along his way. This bias is even more common when a trader is in a loss-making position. To avoid cutting the position at a loss, the trader could search for only supportive information that would justify holding on to the losing position.
Traders who are predominantly bullish or bearish also tend to exhibit confirmation bias. There is a tendency for bullish traders to always be on the lookout for bullish factors, even in overheated markets or in ones that are falling. Similarly, there is a tendency for bearish traders to always be on the lookout for bearish factors, even in markets that are in an uptrend.
By taking a biased or a sided view, confirmation bias can cause traders to make poor decisions based on their pre-conceived notions. It could cause them to:
- Potentially miss out on good trade setups
- Hold on to their losing position(s) for way too long
- See their profits diminish because they held on to their winning position(s) for way too long
How to overcome confirmation bias?
To overcome confirmation bias, you need to take a neutral view and seek out for not only those information that support your view but also those that refute your view. That is, if you have a long position in a stock, do not just be on the lookout of bullish information. Instead, actively lookout for counter information too that would question your bullish view on the stock. Put it in other words, you need to think objectively. That said, it is important that you do not get obsessed with contrary information. If you do so, then any minor move against your position, could cause you to panic and inadvertently act out of emotion.
When a trading position is taken, there are two possible outcomes. One is that the trade goes right, while the other is that it goes wrong. Often, when a trade goes right, a trader thinks that it went right only because of his or her skill and expertise. However, when it goes wrong, it is only because of mere bad luck. What we have here is self-attribution bias – attributing correct outcomes to our own skills while blaming everything else but your rationale for the trade when the outcome turns to be incorrect.
If you are frequently falling prey to self-attribution bias, you are unlikely to learn from your past experience and thereby potentially hinder your progress from achieving success. Why? Well, think about this for a moment. When your trade goes right, it could go right either because your rationale for that trade was indeed right or just because of mere good luck. If your trade has gone right because of luck, then you would not be learning from it as you are under the influence of self-attribution bias. Therein lies the problem, which could hinder your progress. Similarly, if your trade goes wrong, rather than questioning your rationale for the trade and finding out why it went wrong so as to avoid making such mistakes in future, you will just blame luck and refrain from learning from your mistakes.
How to overcome self-attribution bias?
To overcome self-attribution bias, whenever you take a trade, write down the rationale based on which you are taking the trade. Later, when you exit the trade at a profit, find out whether the trade went right for the right reason or because of luck. If it went right because of luck, learn from it so that if the rationale chosen was wrong, you do not commit such mistakes in future. Similarly, when you exit a trade at a loss, rather than just blaming bad luck, understand why the trade went wrong. Was it because the rationale on which it was based was faulty or was it indeed because of bad luck? In case of the former, learn from it so that you can improvise on the trading decisions that you take. Assessing the success and failure of each trade can go a long way in helping you learn from your past experiences and sharpen your decision-making skills.
When a trader executes a trade, he or she does so based on some rationale. When the trade is underway and as new information comes in and causes the price to change, the initial rationale on which the trade was based upon can become obsolete and no longer be of much relevance to the current price and time. However, the trader could still continue giving utmost importance to the original rationale and hold on to the trade based on it. What we have here is a bias called anchoring. Anchoring could cause a trader to hold on to a trade based on information that is no longer valid. This can impair a trader’s decision-making ability, particularly when it comes to exiting a trade. This in turn could act as a hindrance to trading success.
Let us understand this using an example. Let us assume that early morning at 8am, a trader analysed the global markets. He saw that the Asian markets and commodities are trading firmly in green, and all the global and domestic news flows are positive. Based on this, he formed an opinion that for the day, Nifty will trade with a positive bias and accordingly decided to take an intraday long position at market open. As trading commenced, Nifty opened in green and extended its gains for the first hour, in line with the trader’s view. However, the initial rally faded and the index consolidated for some time before reversing its course and ending the day in red. However, as the trader’s initial view was bullish, he held on to that view despite incoming data suggesting that the price structure could be weakening and that the index could be set for an intraday correction. Eventually, nearing the closing bell, the trader exited his position at a loss. Notice here, how attaching himself to his initial view despite signs that the price structure is changing caused the trader to suffer a loss.
How to overcome anchoring?
To overcome anchoring, one needs to have an open-mind and not get attached to the first piece of information on which basis the trade was executed. As time and price changes, the initial information could lose its relevance and new incoming information could start having a greater impact on price. It is important to acknowledge the incoming information rather than reject it and stick to the initial information, so that amendments to the trade can be made, if necessary and at the appropriate time.
When you toss a coin, the odds of getting a head or a tail is 50%. In the context of probability, each toss of a coin is an independent event, wherein a past outcome has no bearing on the current or future outcome. For instance, let us assume that a coin is tossed 10 times, out of which heads turned up on 8 occasions and tails on 2 occasions. On the 11th toss, the probability that tails would turn up is still 50%. The fact that it turned up only twice on the prior ten occasions does not increase the likelihood that it will now turn up on the 11th toss.
A similar logic applies to trading too. From a statistical standpoint, the outcome of each trade is independent of the success or failure of the prior trades. Just because, say, all 5 of the past 5 trades a trader took were loss-making does not mean that the next trade will have a greater likelihood of profiting. However, sometimes, traders tend to get biased and assume that if a particular outcome has occurred on a vast majority of occasions in the past, chances are that the opposite of that outcome would happen the next time. This biasness is called Gambler’s Fallacy.
In trading, gambler’s fallacy can be exhibited not only when entering a trade but also when exiting a trade. For instance, let us assume that a trader is holding a long position in a stock for the medium-term. Let us also assume that the stock has closed on a positive note on 7 of the past 8 sessions. Seeing this, instead of analysing the position, the trader forms an opinion that just because the stock has rallied on 7 of the past 8 sessions, chances are that it could now start correcting. Based on this, he exists the position. Here, the trader has exhibited the gambler’s fallacy bias.
Exhibiting this bias could cause a trader to take excess risks and/or overtrade based on a set of false sense of probabilistic misrepresentation. This in turn could lead to large drawdowns and impair the trader’s success.
How to overcome gambler’s fallacy?
To become a successful trader, you need to keep in mind that trading is a disciplined activity requiring a lot of dedication, subject knowledge, skill, patience, and the right mindset. It is by no means akin to gambling or a get rich quick activity. Hence, when trading, never think or act from a gambler’s perspective, even if it is for a single trade. Instead, you must have a proper trading system in place and take decisions objectively and rationally based on thorough analysis rather than your false representation of probabilities.
In the next chapter, we shall talk about the rest of the trading biases that we intend to cover in the module.
Trading Biases - Part 24 Lessons
In the last chapter, we introduced the concept of trading biases and spoke about confirmation bias, self-attribution bias, anchoring, and gambler’s fallacy. In this chapter, we will speak about some of the other common biases that traders face when trading.
Dealing with Biases and Emotions - Part 14 Lessons
Emotions cannot be altogether eliminated, but can be efficiently managed through discipline and a systematic trading plan. In this chapter, we will talk about some of the ways in which a trader could manage his or her emotions.
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