Trading Psychology
Stock and CFD traders are not just competing with each other in the stock and CFD markets. They are competing with themselves. Traders can be emotional and irrational, and that can make them their own worst enemies.
Such emotions and instincts can provide trading successes, but they are more likely to provide trading losses unless we learn to control them. This is why understanding trading psychology is important.
Many stock and CFD traders would like to divorce themselves from their emotions. Unfortunately, that is impossible, and some emotions may even contribute to trading success. Therefore, it is more useful to learn to understand yourself as a trader, identifying your own strengths and weakness, so that you can opt for a trading style that suits you.
In this section, you will learn about four psychological biases that may adversely influence your trading results, and you will learn what you can do to overcome them:
Overconfidence bias is an inflated belief in your skills as a trader. Any traders who finds themselves thinking that they know the business inside-out, that they have nothing more to learn and that fortunes are theirs for the taking, may well suffer from an overconfidence bias.
Dangers of Overconfidence
Overconfident traders tend to get themselves into trouble by trading too frequently or by placing extremely large trades with the intention of making a killing. It's not inevitable, but an overconfident trader invites disaster.
Are You Overconfident?
If you want to know if you have a tendency to be overconfident, ask yourself, “Have I ever delayed or reversed a decision because I couldn't believe I was wrong?” Likewise, you could ask yourself, “Have I ever put more on a trade than I know is really prudent?”
Overcoming Overconfidence
One way to overcome an overconfidence bias is to stick to a strict set of risk-management rules. These rules should limit the number of markets you invest in, the number of stocks or CFDs you trade at one time, how much you are willing to risk on any one trade and how much of your account are you willing to lose before you take a break from trading and re-evaluate your trading strategy.
Anchoring bias is a belief that the future is going to look extremely similar to the present. When you anchor yourself too closely to the present, you may fail to notice dramatic changes in the offing.
Dangers of Anchoring
Anchored traders tend to get themselves into trouble because they wrongly believe that current trends will never end or that companies they've always favoured will never let them down. Because they are emotionally attached to a stock or CFD, they continue to invest in a way which is not optimal in changed circumstances. With each trade, they lose more money because they are bucking the trend.
Are You Anchoring?
If you want to know if you have any anchoring tendencies then ask yourself, “Have I ever lost money because I couldn't accept that a trend had ended?” If you have done this, you need to be aware of that tendency.
Overcoming Anchoring
One way to overcome anchoring is to seek a new perspective. Look at different time-frames on your charts. If you usually rely on hourly charts for data, look instead at the daily and weekly charts to examine long-term trends as well as levels of support and resistance. You could also examine shorter-term charts to see if trends are reversing.
Broadening your perspective in this way will help you to avoid anchoring yourself to any one point.
Confirmation bias is the habit of only looking for information that supports your beliefs. If you anticipate the price of Google (GOOG:xnas) is going to rise, for example, you will only really take in news and data that reinforce your belief.
Dangers of Seeking Confirmation
Traders who pursue confirmation of their beliefs tend to miss warning signs that would otherwise protect them from unnecessary losses. Ultimately, this can only lead to losing money because decisions to buy or sell, or even to do nothing, are being made on false premises.
Do You Seek Confirmation?
To know if you have any confirmation bias tendencies, ask yourself, “How often do I look for signs that I may be wrong in my analysis?” If your answer is rarely or never, you may be a confirmation seeker and you need to actively work to ensure that such a bias never interferes with your better judgment.
Overcoming Confirmation Bias
One way to overcome confirmation bias is to find an individual or group with whom you can discuss your trading. You don't need somebody who will simply flatter you or perpetually agree with you. Traders with different perspectives and ideas will help you to be more circumspect. Sometimes your convictions will only be reinforced by talking with other traders, but at other times, they may force a total and timely rethink.
Loss aversion bias is based on the theory that losing $1,000 will have a bigger impact on you emotionally than gaining $1,000 will. In other words, fear is a more powerful motivator than greed.
Dangers of Loss Aversion
Ironically traders who fear losses are much more likely to hold onto losing positions than traders who are able to accept short-term losses and exit their trades. A reluctance to give up a losing position will not only cause you to incur bigger losses but also preclude you from finding better investments.
Do You Fear Losses?
If you want to know if you have any loss aversion tendencies, ask yourself, “Have I ever held onto a losing position, beyond the point where I knew I should have quit, because I hoped the trend would reverse and wipe out my losses?” If you have, then you need to be aware of that tendency.
Overcoming Loss Aversion
One way to overcome a loss aversion bias is to trade with physically-set (i.e. automatic) stop-loss orders. Many traders trade with just a mental stop-loss that, when it comes to the crunch, they fail to honour. They let their emotions interfere with their better judgment as they try to justify irrational decisions that prevent them from quitting and cutting their losses.
In conclusion, as soon as you invest in anything you should set your stop-loss order. It should be physically set, operate automatically, and you should respect it.
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