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Cognitive Bias That Can Affect Your Trading

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Cognitive Bias That Can Affect Your Trading! How to Combat It

As you will come to learn trading in financial markets especially forex, stocks and crypto is as much dependent on the psychology as it is on strategy. Cognitive biases are systematic deviations from rational judgment and are a common cause of traders ‘decision-making. Both traders need to know about cognitive bias because there is no trader that cannot improve his or her earnings and overall performance from the knowledge.

In this article, read on to learn some of the biggest cognitive biases that could impact your trading plus how you could tackle those. From this guide, one is guaranteed to upgrade on his/her capabilities of making sound, bias-free decisions when trading.

What Does Cognitive Bias in Trading Mean?

Cognitive bias is the unconscious pattern of failings that characters in trading undergo when making decisions and making judgments. These biases happen when the brain, due to an effort to make handling information easier, uses certain default settings, known as heuristics, which may give wrong results. These dissertations if developed can have a negative bearing on a trader’s decision making, profitability and the overall strategic plan or direction of a business in trading.

How Cognitive Bias Affects Trading Decisions

In relation to trading, cognitive biases appear in different forms, affecting the trader’s actions to some extent making it impossible for them to act rationally. Here are some common cognitive biases that traders encounter:

Overconfidence Bias

Overconfidence bias is the situation where traders tend to overemphasize relatively what they know or their ability to forecast the market. Of course, this may lead to an increase of risks, high frequency of trades, or complete ignorance of the proper risk management rules. Another type of trading psychology is overconfidence bias one has to remind himself over and over again that a trader should never take himself too seriously.

Example: Overconfidence bias in trading forex

It is not rare to see a trader making lots of money in a bullish market; probably that is the reason one could get too carried away with himself / herself. They may be inclined to think that the future prices of these securities will be easily forecasted and thus they end up holding larger lots than they ought to. At some point, the market rebels and their unwavering confidence proves to be costly for them.

Pro Tip:

Ensure that you cast your eyes on your previous trades and try to analyze which trade was good for you and which was not good for you. This feed-back can be used to modify strategies in use.

Anchoring Bias

Anchoring bias occurs when a trader relies primarily on a particular price, number or any other fact in making the trade. For instance, a trader will develop a tendency to look at the entry and ignore all the other indicators of a particular trade and he will be expecting the price to go back to the entry price.

Example: Self-serving biases in stock investment self-generated hypothesis-confirming effect

A stock trader has a positive or bullish view of a certain company’s stock, and he begins scanning for articles to read, reports from analysts, and signs in charts pointing to the continual upturn of the stock price. They reject any information that does not support the positive bias and hence make an incorrect decision on investment.

Pro Tip:

The trading rules created should be domino effect always have an exit strategy and predetermined risk management rules. Do not get fixated with a certain price level.

Confirmation Bias

If you have a certain belief in a particular matter, you are more likely to look for evidence to support your point in regard to trading. In trading this could lead to rejection of ideas that differ with one’s look at the market in terms of demand and supply.

Pro Tip:

Be open to new perspectives. Do not rely on a single source of information to come up with a rationale when making a trade in the market.

Loss Aversion Bias

The prospect theory states that an trader has loss aversion bias where volatilities are disliked more than equivalently sized gains are liked. This leads to either; staying with a less performing trade too long, or cutting a good trade in an attempt to avoid the feeling of a loss.

Example : Loss Aversion in Day Trading

Another psychological attribute of traders affects their ability to cut their losses; a day trader, for instance, may hold an erroneous position longer than appropriate, because he/she cannot bear to make small losses, expecting a change in direction in the market. This fear of getting to the point of knowing that one has incurred a loss results in even bigger losses as the market keeps on shifting against you.

Pro Tip: 

Order exit points, and stick with them. Understand that there will be occasions where you lose on trades and let go of such bad experiences fast.

Recency Bias

Recency bias is closely linked to forecasting and implies that more importance is attache to near-time observations rather than figures of long ago. Traders might tend to work extra hard to exploit recent market trends and price movements without ought to lose focus with the general trend.

Pro Tip: 

Try to set your vision much longer than you expect to prevent creating decisions based on short-term market conditions. Stick to the strategies of your trading plan and do not be lead by your emotions.

How to Overcome Cognitive Biases in Trading

Having discussed some of the most widespread cognitive biases that could impact your trading decisions let’s continue and find out how to avoid them. Here are some actionable steps you can take:

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Develop a Trading Plan

It also means that a clearly worked out trading plan minimizes the role of emotions in the trade. To stay disciplined, you need to set specific goals, entry and exit points, and risk control rules so that you cannot be swayed easily by a particular bias.

Pro Tip: 

Follow the strategies that have been laid down and should not make a decision to trade because of influence from feelings or any sounds heard from the market. This will help reduce biases that can result in to wrong decisions being made.

Use Data and Analysis

Gain the skills of trading with information instead of acting impulsively because of some intuition. This involves the employment of technical, fundamental and backtesting approaches with a view of evaluating a trade profit potential.

Pro Tip: 

Ensure that you get all the information you can in the market and find it wise to take your own time in trading. This will help you in making the right and more of often bets that are more informed, and backed up by facts and figures.

Calm Body and Mind: Reduce Operating Stress

Everyone gets periods of high and lows when trading and it depends on the trader how well he or she should handle them. Practice relaxation forms including meditation, deep breathing or writing down deeply in volatile periods in the markets to help you remain fully on the ball.

Backtest Your Strategy

The backtesting allows you to testing your trading technique in various conditions of the market. Backtesting is valuable because errors and possible biases are first discovered when testing, not after live money has been lost.

Pro Tip: 

One should take time and go through the trades as well as the strategies in order to be able to recognize if there’s a biased view. In trading, it’s crucial that changes are made as often as needed towards reaching greater levels of profitability.

Major risk management tools

The most important goal in using them is to manage risk in order to minimize the effect of heuristics on the trades. To minimize the impacts of bad decisions; employ stop loss orders, right position sizing strategies and try to diversify.

Why Do You Need to Be Aware of Cognitive Bias?

Understanding and managing cognitive bias is crucial for several reasons:

• Increased Profitability: Traders who are conscious of cognitive biases will thus make better decisions leading to better and reliable profitability.
• Reduced Emotional Stress: Thus, controlling biases, traders can let away emotions which cause most of the terrible trades and increase one’s level of stress.
• Improved Risk Management: Knowledge of cognitive biases assist traders control risks by avoiding reckless decisions that can increase their exposure to risks.

On Mojo4x, you will find all the materials to learn how best to trade and avoid the effects of cognitive bias on your trading operations. If you are concerned about the structure of your trade information and where you are putting it, then you should look at our Forex Trading Journal Templates.

People Also Ask

What is cognitive bias in trading?

Cognitive bias in trading occurs when traders display biased thinking that could impact their profit level.

How does cognitive bias affect trading?

It causes unwise choices, such as overconfidence or denial of market signals, leading to losses and missed opportunities.

How can traders avoid cognitive bias?

Traders can overcome bias by creating a plan, working with specific data, and staying away from emotional decisions.

What are common cognitive biases in trading?

These include overconfidence, anchoring bias, and loss aversion, which can hinder decision-making and risk control.

Why is cognitive bias important in trading?

Cognitive biases are important as they help traders make rational decisions, improving operational efficiency and profitability.

How do you manage cognitive bias in trading?

Manage cognitive bias by trading with a clear plan, using risk management strategies, and making data-driven decisions.

Can cognitive bias affect long-term trading?

Yes, cognitive bias can be harmful to long-term trading by leading to suboptimal decisions and inconsistent profits.

What is loss aversion bias in trading?

Loss aversion bias occurs when traders stick to losing trades longer than necessary, fearing the loss more than appreciating gains.

Conclusion

Trading Psychology is about understanding that though cognitive biases are ingrained in the operating system of a human being, it can be lethal in the trading business. It is high time to increase awareness of these biases and learn how to deal with them on the way to becoming a better trader and achieving better discipline. Therefore you will be able to minimize these effects and improve the results of trading by following a defined system, deciding based on the data and documents, and regulating the emotional state.

For more information on trading strategies and tools get in touch with us through Mojo4x Blog and get access to our collection of trading books aimed at every level of trader. Leverage on the collected information and a disciplined trading attitude to help master the financial markets.