Trading markets are full of surprises; when it comes to trading in the foreign exchange market, some of the surprises can result in losses due to trading mistakes. While some mistakes are part of the learning process of trading, other mistakes can be costly and difficult to identify as they are often rooted in the biases that traders hold and how they interpret data. Although biases were created to help us maintain an organized perception of the world, they can have a distorting effect on our trading decisions, leading to losses. In order to minimize this risk, it is important to become aware of biases and then develop strategies to overcome them. In this article, we will explore how to identify trading biases and then develop tactics to help overcome them while trading in the foreign exchange market.
What are trade biases?
Trade biases, or cognitive biases, are mental shortcuts taken by traders when making decisions. They are often rooted in psychological and mental impediments, and can lead to seemingly illogical decisions. This can hurt traders’ trading results and lead to excessive risk and losses.
Trading biases are typically either emotional bias or mental bias. Emotional bias is driven by instinct, a trader’s feelings or intuition, and can be very difficult to overcome. Mental bias, on the other hand, is usually caused by the application of logic or math to activities like trading. It can be overcome through the use of a well-defined trading plan and more careful attention to risk management.
The top six biases in trading
The following six biases are the most common problems traders face when trading in the Forex market:
- Herd Mentality Bias – Following the crowd without considering individual needs.
- Confirmation Bias – Seeking to only confirm existing beliefs, or disregarding internal warnings or contradictory evidence.
- Over-trading Bias – Entering too many trades, often due to the pursuit of profits or to avoid losses.
- Leverage Bias – Using excessive leverage to increase returns, or taking on leverage when it is not necessary.
- Loss Aversion Bias – Being overly-resistant to sell a losing position, and being overly eager to sell a winning position.
- Recency Bias – Assuming recent results are indicative of future outcomes.
Overcoming trading biases
The best way to overcome these biases is to become aware of them and to have a rigorous trading plan in place. A trader should know what their trading style is and what they’re trying to achieve. Having goals and objectives can guide decision making, keep emotions in check, and prevent traders from getting over-committed to a single trade.
Traders should also maintain a journal, as this can help them gain a better understanding of why they’re making certain decisions. Writing down trades, recording profits and losses, and noting emotional states can provide a clearer picture of a trader’s performance and help them identify patterns of bias.
Traders can also implement trading strategies that take into account their own individual risk tolerance. Risk management tools like stop losses and position sizing can help keep emotions in check and limit losses.
Finally, it is important to remember that trading can be a long-term process, and that the markets will inevitably have their ups and downs. It is much more effective to take the long-term approach and focus on overall trading performance rather than short-term success or failure. By maintaining mental discipline, traders can overcome their biases and maximize their chances of success in the long run.