How Understanding Prospect Theory Can Help You Trade Smarter

Forex trading is a demanding but potentially rewarding activity that requires a good understanding of the political and economic factors that drive the market, as well as technical analysis skills. However, to fully master the nuances of forex, it’s also important to understand the psychology of trading.

There are numerous resources available on this topic, but one of the most useful and insightful guides is Prospect Theory, which was first introduced in 1979 and developed further in 1992 by Amos Tversky and Daniel Kahneman, and won the Nobel Prize in Economics.

Here’s a closer look at what Prospect Theory is, and how it can be applied to forex trading so you can make the most of an instant funded account.

Understanding Prospect Theory

Prospect Theory is based around the concept that traders value losses and gains differently, and that they place more value on potential gains than potential losses, even if the possibility of both is equal. It’s part of the wider theory of behavioural economics that accepts that people do not always make rational and unbiased decisions when dealing with finances.

Kahneman argues that when people make decisions that will affect their personal financial situation, they are based on their most immediate emotional reactions, rather than a detached assessment of the long-term outcomes.

Gains and losses are short-term outcomes, and because humans are hardwired to dislike losing, they will subconsciously be biassed towards gains.

This can lead to traders taking bigger risks than they might assume, because they are not giving equal consideration to the potential losses. This behavioural theory is sometimes also referred to as ‘loss aversion bias.’ Some psychologists believe that the pain of losing is twice as intense as the joy we experience from a successful outcome.

This may be an evolutionary trait that lingers from the time when protecting ourselves from losses was more likely to ensure our survival than basking in a victory. For our ancient ancestors, avoiding the intense physical pain of being attacked by a predator, with a possible fatal outcome, is obviously more of a priority than securing a tasty dinner by making a kill.

Some psychologists believe that this behavioural trait is still apparent in our decision making processes today. This can result in cognitive biases towards avoiding losses. We are still socially conditioned to fear losses that may not be physical, but can be economic or emotional.

For example, no one likes to see their football team lose a match, or be rejected in a social situation such as dating. Money is something that we all need not just for survival but also to have some freedom of choice over the way we live our lives, so it is not surprising that it can bring out primal emotions such as fear and greed.

Rather than face up to the prospect of a painful loss, our minds can subconsciously focus on the more pleasurable and positive prospect of making a gain. When it comes to forex trading, this can lead to a tendency to hold on to a losing position for too long in the hope of breaking even, or of selling winning positions too early to lock in gains.

Framing

When faced with a choice that has a 50/50 probability of making a gain or a loss, humans can have a tendency to frame the choice as a potential gain rather than a potential loss. This can prevent an individual from considering all of the available information with equal weight.

Another aspect of Prospect Theory is that it can lead to traders underestimating outcomes with low probability, and overestimating outcomes with high probability. This can lead to traders being caught out by sudden market swings, which is a common occurrence in the volatile forex markets.

Overconfidence

Prospect Theory identifies overconfidence as a common trait in financial traders, and a false sense that they can accurately predict or control events. It is impossible for even the most skilled traders to accurately predict the way the markets will move, and forex trading is all about weighing up probabilities in order to take controlled risks.

When a trader has an illusion that they can control or accurately predict market movements, it can lead to overly risky trades that overlook the prospect of losses and overemphasised potential gains.

Anchoring

Anchoring is another cognitive bias that is known to influence the behaviour of forex traders. It is the human tendency to rely too heavily in the first piece of information available when making a decision. However, this is not always the most objective and impartial information, but it ‘anchors’ in the mind and is used as a yardstick to measure all further sources against.

When forex trading, this can lead to basing all future decisions on the earliest technical analysis or economic data, rather than adapting to the latest available information. Forex traders need to be aware of anchoring bias, and ensure that all of their decisions are made on current market data, rather than taking a mental shortcut to their first impressions.

How can forex traders overcome cognitive biases?

The concepts described above are known as cognitive biases, and are a widely acknowledged issue in the high-stakes world of financial trading. Forex traders may consider themselves to be immune to biassed thinking, but these cognitive processes can be conscious or unconscious.

It is not possible, or even desirable, to completely eliminate all biases because they are deeply embedded in our thought processes. They can help us process a lot of information quickly by building up mental shortcuts, and avoid us having to go through unnecessary steps each time we want to carry out a task.

However, over time we can create selective thought patterns that stop us from considering the whole picture. In forex trading, this can put us at a disadvantage because it can lead to us forming conclusions based on limited or outdated information.

The first line of defence is to acknowledge that you are prone to biases such as those outlined by Prospect Theory. It is not a sign of mental weakness, but a normal and sometimes necessary part of our psychological make up: we are naturally attuned to fear the pain of loss more than the pleasure of success.

Even if you consider yourself a competent and well-informed trader, you should always be on your guard against biassed thinking. The second line of defence is to form a clear trading strategy and align it with your risk management strategy.

When you are making a trading decision, always refer to your plan and be vigilant for any emotional impulses that could be causing you to deviate from it. Another good strategy is to keep a detailed and accurate account of all your trading activities, so that you can periodically review your progress.

This will give you the opportunity to identify any situations where you have been loss averse. For example, are there trades where you have sold earlier than your stipulated price point, because you were anxious to lock in the profit? Would the outcome have been more profitable if you had stuck to your plan or carried out a fresh market analysis?

There may also be examples of trades in a losing position that you have hung on to for too long, rather than bite the bullet and accept the loss. In the majority of cases, this behaviour will probably only have amplified the loss, whereas selling at the limit specified in your trading plan would have minimised it.

When making a trading decision, try not to focus purely on the gains or losses, but objectively weigh up the probable outcomes. Adopt a neutral frame of mind, and avoid short-term thinking.

The key to making steady profits in forex trading is to keep your focus on the bigger picture: it takes new traders several months or even years to become consistently successful, and even then it will be necessary to accept some losses along the way.

Condition yourself to see losses as a sometimes necessary business expense that is part and parcel of the trading process, rather than a sign of personal failure. If you are taken by surprise by a steep loss, step back and process any resulting emotions such as anger, shock, panic, fear, shame, and so on.

It is normal to feel this way occasionally, but the key is to be aware of the emotion and not to act on it. Work out what went wrong, and adjust your risk management strategy accordingly, rather than compound the error with a poorly thought out and subjective action.

Prospect Theory and associated theories such as loss aversion bias can give traders greater insight into the subconscious processes that can influence their decision making.

This can improve their trading outcomes by learning how to recognise when their judgement might be skewed, and adopting suitable risk management strategies to help buffer themselves from the effects of these biases.