Updated from its original posting on 2011-06-10
Having biases can severely impair our ability to read the markets objectively and make good trading decisions. The first step to overcoming these biases is to become fully aware of them. Below, you’ll find a list of five of the most common forex trading biases. Which ones are you guilty of?
1. Recency bias
Do you often find yourself zoning in on your most recent trading decisions, thereby losing sight of the big picture? Then you, my friend, may be guilty of having a recency bias!
Recency bias has a way of clouding judgment and impairing good decision making as it involves unnecessarily placing too much importance on the most recent events. But it doesn’t just apply to trading decisions, as in the case of losing confidence after a couple of losses. It can also affect the way you analyze the markets.
If you focus too much on one economic event and fail to take into account the larger fundamental background, or if you limit your analysis to the most recent candles and lose track of long-term trends, you are just as guilty of committing recency bias.
To cope with it, take a step back and assess the longer-term situation of the forex trade or your portfolio. Always keep the big picture in sight, and don’t allow your last success or failure cloud your judgment.
2. Confirmation bias
As humans, we tend to listen more to analyses that support our own views and opinions and undermine those in opposition. After all, it’s in our nature to want to be right…. Right?!
The problem with this is that it makes our trading decisions all the more subjective. It’s easy to ignore signs of bearishness from the market if you’ve read very bullish analyses and have already set your mind on going long!
Fixing this is a matter of being flexible and open to others’ opinions. A different set of eyes may see things that you don’t. The best way to get a balanced outlook and see both sides of the coin is to consult different analysts. Make it habit to mix up your daily reads by checking out Forex Gump’s blog, Pip Diddy’s commentary, and other forex trading blogs to get a clear, unbiased assessment of the markets.
3. Herding Bias
Did you ever back out of a trade when you found out that a bunch of other traders are taking the opposite forex position? If you said yes, then you have fallen victim to herding bias.
Just as sheep try to move with their flock, traders also tend to follow the majority and often feel uneasy about straying from the crowd. It’s human nature and we just can’t help it, right?
As a trader, you shouldn’t be afraid to take the contrarian position. Just make sure you did your homework, conducted proper fundamental and technical analysis, and planned your trade well. If you have enough reason to believe that the markets are about to turn, you don’t have to simply go with the flow and jump in the ongoing trend just because yo momma and yo momma’s momma said so.
If you need additional confirmation to take a trade that seems to run contrary to popular opinion, our lesson on gauging market sentiment might be able to help. You could use the COT trading strategy to see if small speculators are crowding at tops or bottoms and call a reversal ahead of everyone else.
4. Attribution Bias
Psychologists define attribution bias as cognitive errors in the way people determine who or what was responsible for an event or outcome. Say what?!
In trading, attribution bias manifests itself when you credit your own mad skillz for winning trades and blame losing trades on outside factors, such as the unpredictability of the markets or on your uber slow internet connection.
My all-time favorite trading psychologist Dr. Brett Steenbarger says that having such kind of bias can distort our decision making. How can you take control of your trades if you keep thinking that everything that can go wrong is out of your control? More so, if you don’t give credit where credit is due, how are you supposed to identify those bad trading habits that you need to correct?
This is where the importance of having a detailed trade journal comes in. List the things that you did right, what you did wrong, what you expected and didn’t expect, and what you could’ve done better. According to Dr. Steenbarger, this will help you take ownership of your strengths and weaknesses, which would will hopefully make you become more mindful of your trading processes.
5. Addiction Bias
As traders, we have a very clear memory of our “hall of fame trades,” just as a fighter remembers his glory days vividly. Remember that it’s not enough to hold on to memories of those big winners; the numbers should support it. After all, you want to take trades that have a high probability of working out for you.
If you’re guilty of any of these forex trading biases, you better take steps to remedy that. There are plenty of tools and resources out there so you don’t have any excuses not to kick those bad habits out the window!