How To Beat The Disposition Effect In Forex Trading
In forex trading, the disposition effect refers to the psychological tendency to sell assets that are making a profit too early, and to hold onto losing assets for too long, in the hope that things will turn around. Both of these behaviours are a barrier to making the best rewards from your forex trading. Here’s a look at how you can overcome it.
Acknowledge your biases
Psychologists think that we react disproportionately when faced with a potential gain or a potential loss, because the pain of losing is more intense and damaging that the pleasure of making a gain. This probably has a sound evolutionary basis, because in previous eras, it could literally mean the difference between life and death.
So we are talking about powerful and primitive human emotions here, which to a certain extent, we have learnt to supress in modern life. However, our subconscious mind is always at play, and when we are under pressure and the stakes are high, our emotional state can go into red alert.
Even experienced professional traders stay on their guard against the mind’s natural tendency to be loss averse, and conversely, to take irrational risks. It is not a sign of weakness to admit that sometimes, we all make subjective decisions based on gut reactions, rather than analytical and objective decisions.
In fact, acknowledging you will sometimes take illogical risks, or be too loss averse, is a sign of mental strength. It’s the way the human mind is designed. Admitting it puts you in a better position to understand and tackle your biases, and therefore makes you less prone to letting them get in the way of a sound trading decision.
How do you recognise the disposition effect?
So, you’ve accepted that you are prone to the same patterns of thought as everyone else. You are already gaining a competitive advantage over your trading rivals, by understanding the need to tackle the disposition effect in your own trading.
Review your records of your last month’s trading. Look for situations where you have closed a profitable position quickly, when holding out for longer would have led to a bigger profit. Also look at your losing trades. Have you hung on to any of them in the hope of a price swing, even though you had no logical evidence that this may happen?
If you can see a tendency to settle for the minimum profit, and/or hold on to a losing position for too long, thus increasing your losses, then you are falling prey to the disposition effect. Even if you don’t see these patterns, or you are a novice without much experience behind you, it can still help to broaden your understanding of cognitive biases.
Overconfidence and pride can be just as dangerous as excessive loss aversion when it comes to forex trading. There’s nothing wrong with enjoying your successes, or feeling disappointed in failure; after all, these are often the emotions that drive us all. However, a good trader is always on the lookout for pitfalls, and keeps an eye on the bigger picture.
Loss aversion, cognitive bias, the pleasure/pain principle, subjective thinking, the greed and fear drive, being led by the emotions; call it what you like, we are all prone to it, especially when we are under pressure to make a quick decision.
How do you avoid it?
On the face of it, avoiding the disposition effect is straightforward: don’t hold on to losing positions for too long, and don’t sell profitable ones too soon. However, as we have seen, the mind has a natural bias to do both of these things. Neither will lead to optimal success as a trader, and if unchecked, it can cause real damage financially and personally.
Have a clear trading plan
One of the most effective ways to keep your thought processes clear and rational is to plan ahead. Setting targets which are compatible with your trading goals and risk tolerance levels, and then having the mental and emotional resilience to stick to them, is the number one method to avoid making unplanned and unwise trading decisions.
However, avoid setting yourself fixed numerical targets. Rather, form your plan around determining your position size, and defining your entry and exit points. Above all, your framework should be based on the well-known SMART acronym: it must be Specific, Measurable, Achievable, Relevant, and Time-bound.
Know your risk parameters
Start by defining your risk tolerance. This means making an honest and realistic assessment of how much capital you have to play with. Make a spreadsheet documenting your monthly income and outgoings, and any savings you wish to use as capital. This will give you an idea of how much of your own money you are willing and able to invest.
A modest amount of capital is no barrier to entry into trading, because many brokers will offer forex instant funding with leverage. However, you must decide in advance how much loss you are prepared to risk on each trade. This should be in proportion the amount of capital you have put up.
If the loss margin is enough to keep you anxiously glued to screens and charts for hours, then it is too much! Your trading decisions will be more likely to be based on fear and greed, than a sound trading strategy. The amount you can stand to lose should not leave you feeling edgy and uncomfortable.
While some of the psychological traits we have discussed are universal to all humans, we are also individuals with different temperaments and personalities. Some of us tend to be phlegmatic and methodical, others are more highly strung and impulsive. We can learn to use our individual traits to our advantage in trading.
For example, a thorough and detail orientated person will thrive on market analysis and may have the edge in making logical decisions. However, they should be aware not to let their risk aversion get the better of them.
A more instinctive person who likes to keep an eye on the bigger picture may have the advantage in getting ahead of a curve and making quick decisions. However, they may need to guard against unnecessary risk taking and overconfidence.
Look after yourself
Whatever your personality is like, we can all benefit from a lifestyle that boosts our mental and physical wellbeing. When we are well nourished and well rested, we are going to make better decisions, and be less tempted to cut corners and take risks, than if we are stressed and burnt out.
Avoid letting your trading become all consuming, whether you are working it around a day job, or making it your full-time occupation. It is important to have downtime, whether to socialise, exercise, or just chill out. It allows the mind to process the events of the day, and keeps our resilience levels topped up, so we are not floored by minor setbacks.
Many traders, as well as other highly successful entrepreneurs, like to include some meditation time before they start their day. This helps to focus the mind and sets them up for the rigours ahead. The techniques can also be drawn on in stressful moments throughout the day, to help with mental clarity and concentration.
Meditation can take a bit of practice if you’ve not tried it before. There are plenty of apps and books which can talk you through simple techniques, such as diaphragmatic breathing, progressive muscle relaxation, and so on. It’s worth preserving with even it at first, you find it difficult or don’t notice the benefits straight away.
Over time, you will find that even 10 minutes of sitting quietly can help you ground yourself, and move beyond those superficial thoughts and emotions which tend to crowd our minds during the daytime. Some people find it helps them with the more abstract thinking that is useful when analysing graphs and charts, and other market data.
Beware of social pressure
Be careful about your social network, both on and offline. If you mix with other traders and swap stories, be aware that this may lead you to seek pride, and become overly fearful of regret and loss. Peer pressure, and the tendency to try and boost our social status, can lead to emotional rather than rational trading decisions.
Our mind’s negative bias means that regretful thoughts often keep us awake at night, going over what you should have done, or what might have been. Unfairly, our successes rarely have the same impact. We could have experienced five successful or pleasurable events during the day, but it will be one negative experience that comes back to haunt us.
Good traders learn not to wallow for too long in success or failure. This is a well-known technique of positive psychology, which is useful to learn about, not just in a trading context; it can help with other areas of our professional, personal, and social lives.
In conclusion, we need to acknowledge the disposition effect in trading, and combat it through a solid trading strategy, combined with building up an emotional distance around our decision making.