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2024/08
Understanding cognitive biases in trading: Insights from experienced traders
There are often no shortcuts or easy paths in trading, especially since “trading is counterintuitive.” Your comfort zone will gradually erode, and your edges will be smoothed as you participate. Those who can adapt to this grinding process may succeed, while those who cannot will undoubtedly fail.
Here, experienced traders share their insights on cognitive biases that significantly influence market judgments and determine trading outcomes.
Trader 1
Top traders mainly master the various manifestations of human nature in trading, discovering its weaknesses and actively countering them. The “Turtle Trading Rules” list several cognitive biases significantly affecting most traders.
Loss Aversion
Many traders prefer not making a profit over stopping a loss, leading to eventual account blowouts. Professional traders, however, are decisive about stopping losses, treating it as casually as drinking water or eating.
Sunk Cost
Sunk costs are expenses already incurred and cannot be recovered. Many traders desperately try to recover these costs, leading to bad decisions. It’s crucial to stop losses when necessary and not overly focus on sunk costs.
Aversion to Uncertainty
Also known as the disposition effect, this refers to cashing in early due to a dislike of uncertainty. Successful trading requires embracing uncertainty and holding onto trending markets instead of taking profits early.
Outcome Bias
This bias leads traders to judge trades by their outcomes rather than logic. Professional traders focus on the trading logic, believing that even a losing trade is suitable if the logic is correct.
Recency Bias
Traders often place more importance on recent data or experiences, frequently changing their methods after losses. Understanding that every method has unfavorable periods and seeing the bigger picture is crucial.
Trend and Herding Effects
Many traders need to verify information themselves to follow the crowd. Insight is crucial to avoid these effects and ensure decisions are based on personal analysis rather than popular opinion.
Anchoring Effect
Traders rely heavily on initial information (the “anchor”), remaining unmoved when prices fall but rushing to exit when they rebound. Setting a reasonable exit strategy and tolerating drawdowns are necessary to counter this effect.
Trader 2
In trading, human nature can be summarised as greed and fear. Countering these is the essence of “being counterintuitive.” Overcoming these requires self-discipline and effective strategies.
For example, an initial trend trader might struggle to hold positions for several reasons:
- Fear of Losing: Traders often have unreasonable stop-loss spaces and frequent stop-losses, abandoning correct predictions. Significant losses may cause them to miss out on trends or hesitate to trade when the trend emerges.
- Fear of Winning:After catching an opportunity, traders might secure quick profits and exit early, deviating from their strategy. Understanding market rhythms and adhering to the strategy is essential.
Subjectivity is unavoidable and reflects an understanding of the market. It can bring greed and fear, but strict adherence to trading discipline can mitigate these effects.
Greed and fear stem from ignorance about the unknown. Understanding the market, risk, and trading purposes can help dissipate these negative feelings.
Trader 3
Trading systems need to be more counterintuitive; adhering to them is.
There are countless profitable systems, but they all converge on different levels of trend following. Once you have a profitable trading system, you must follow it counterintuitively.
- You start trading with the system and make money. If the system uses a 10% position to make $1,000, increasing it to 50% should make $5,000. You change it and end up blowing your account.
- You start trading with the system and make money. The system suggests a long position one day, but it’s at a resistance line! You skip the trade and end up losing. Another day, the system suggests stopping at a loss, but there’s support just below, so you skip the stop loss and lose more.
- You start trading with the system, but losses shake your confidence. The system signals an entry, but you don’t take it, thinking it’s a bad entry point. A big trend then occurs, and you miss out.
- You start trading with the system, making a 10% profit in the first half of the month and losing 8% in the second half. The following month, you make 10% again in the first half and think you should stop, only to find that the system could have made 40% in a month.
- You start trading with the system but notice it needs to catch up on some market moves, so you over-optimize it, causing it to fail and lose money.
Conclusion
Understanding and countering cognitive biases is crucial for successful trading. By learning from experienced traders and adhering to disciplined strategies, traders can navigate the challenging yet rewarding market trading process, increasing their chances of making substantial and lasting profits.
