Ever heard of the good ol’ recency bias? The phrase gets thrown around a lot in the foreign exchange market, so I thought it would be nice to talk about it in today’s issue of Pipsychology.
First and foremost, what exactly is recency bias in forex trading?
In the most basic sense, recency bias pertains to the tendency of traders to look at only the most recent events while disregarding older but equally important (or sometimes even more important) pieces of information. Recency bias negatively affects the way a trader analyzes the market, as it clouds his judgment and damages his decision-making skills.
In forex, the most common manifestation of recency bias is when a trader zones in only on his most recent trading decisions and loses perspective on the bigger picture.
An example of this is a fundamental trader that puts too much meaning in an economic event that just happened and fails to take into account the larger macroeconomic background. Another example is a technical trader placing a lot of weight on newly formed candles, making him lose track of the long-term trends.
There is also a psychological aspect to it. Let’s say there are two traders. The first trader, Mike, has won his last 3 trades and has an overall record of 4 wins and 6 losses. Mike’s account is up 1% year-to-date. The second one, John, is oin a 3-trade losing streak. John’s record is 8 wins and 7 losses and his account balance is up 5% year-to-date. Mike is extremely joyous about his winning streak while John is down in the dumps.
But if you look at the bigger picture, it is pretty clear that John is ahead. He has more wins than losses and even his percentage gain is much larger than Mike’s. If Mike and John aren’t careful, they could succumb to recency bias which could adversely affect their future trade decisions.
Mike could end up ignoring possible warning signs and enter a trade hastily while John could become frustrated, abandon his risk management rules, and start overtrading. Both situations are clearly undesirable.
If you often find yourself in those situations, here are some tips to help you avoid having recency bias in trading:
1. Keep a detailed trade journal
As we’ve discussed in the School of Pipsology, keeping an accurate trading journal is almost as good as having a coach watching over your shoulder and keeping track of your trade decisions. By monitoring your progress along with the right and wrong moves you’ve made, you’ll be able to have a bird’s eye view of your overall trading performance and avoid zoning in on only your recent trades.
2. Write down your trade plan and make sure you stick to it.
If it helps, you can come up with a checklist of all the criteria that should be met before entering a trade. This way, you’d be less likely to give in to your emotions – whether it’s overconfidence from your winning streak or increased hesitation after a trading slump – and be more focused in executing your trade plan.
3. Engage in deliberate practice.
As I’ve mentioned in my previous articles, engaging in deliberate practice can remind you why you created your trade plan in the first place and why it works. Aside from that, it can help you stay in sync with the dominant market themes and allow you to make adjustments to your trade plan if necessary. By doing so, you’ll be able to take the bigger picture into consideration and assess your trading performance at the same time. Talk about hitting two birds with one stone!
4. Know yourself.
Last but certainly not least, knowing yourself well is one of the best ways to steer clear of recency bias. If you feel that you are likely to give in to your emotions, step back and try to make a more objective assessment of your previous trades.
If you think that your losing streak is causing you distress, you might need to take a day off from trading or a quick vacation. Take it from Pipcrawler who finds listening to classical music for a couple of hours as the best way for him to shake off negative vibes when in the middle of a slump. For some traders, self-dialogue or talking out loud while trading does the trick. What’s important is that you figure out what works best for you.