Understanding Cognitive Vs Emotional Biases In Forex Trading
Forex trading is not just about developing a solid trading strategy: it’s the decisions you make in the heat of the moment that really count. None of us can act in a truly objective and unbiased way 100 per cent of the time, and this can cloud your judgement and negatively impact the outcome of a trade.
Our emotions can also distort the decision making process, often before we realise it. Strong emotions can be erratic and arise suddenly, and the high stakes and intense pressure of making quick financial decisions can amplify whatever emotions we are experiencing.
This is why successful traders work just as much on cultivating their mindset as they do on their trading plan. The mental and emotional aspect of trading is broadly classified into two types: cognitive biases and emotional biases. They occur from distinct psychological processes, so it’s helpful for traders to gain an insight into how they impact their decisions.
Here’s a closer look at the differences between these biases, what they typically involve, and strategies to manage them.
Cognitive biases
Cognitive biases are subconscious thought patterns that can lead to errors in logical thinking, and influence judgements and decisions. It is impossible to be entirely free of them, because it is the brain’s way of making mental shortcuts and protecting our minds from information overload: no one can ever know everything.
These biases affect us all in unique ways, because we all interpret information differently and have different memories and educational and social experiences. Often we are not aware of biassed thinking in our everyday lives, because it can be subtle and deep-rooted. However, it’s important to understand how they might influence your trading decisions.
Confirmation bias
Confirmation bias is when we seek out information that confirms our existing beliefs and opinions, and ignore anything that contradicts or challenges them. We may also assume that everyone else shares the same views, and that there is nothing further to learn about a topic beyond what we already know.
This type of selective thinking can mean that traders miss out on valuable information when carrying out fundamental analysis, and this can weaken the quality of their trading strategy. It can also result in errors in the interpretation of technical analysis tools, because the trader may look for patterns that confirm their expectations, rather than draw objective conclusions.
For example, if you believe that the market is bullish due to sentiment on social media, this can lead you to adjust your exit points from a trade in the expectation that the value of a particular currency will rise. However, the opinions of economists and respected news journalists might provide a different view, which you failed to take into account.
Overconfidence bias
Overconfidence bias is a pitfall that can catch out some new traders, particularly after a big win or a run of successful trades. This can create a false sense of confidence that is not based on the reality of the trader’s knowledge and skills, but an inflated belief in their ability to interpret the forex market.
This can result in the trader taking bigger positions or making too many trades, and being less cautious with their risk management policy. This can expose them to significant losses, because of the cognitive gap between what the trader believes is right, and what the best course of action should be.
Anchoring bias
Anchoring bias is the tendency to fixate on the first piece of information a trader finds about a particular market opportunity, and use that information as their reference point without adjusting their thinking when they encounter further information. The first reference point may be entirely arbitrary, and there is no justification for prioritising it.
This can be damaging for forex traders, because it may cause them to miss the ideal time to exit a trade and hold on past its peak. It can also result in them selling too early in a trade, or trading with underperforming currency pairs. Anchoring bias may occur when a trader is rushing or making too many trades that are under researched and likely to perform poorly.
Disposition bias
The disposition bias, also known as the disposition effect, can sabotage your chance of success in forex trading by prompting you to sell profitable trades too early, and to hold on to losing trades for too long. This is a natural human trait to try to protect our assets, and it’s a complex cognitive bias because it can be subtle and crosses over with emotional biases.
Almost all of us are conditioned to be loss averse, because we fear the pain of losing more than we seek the pleasure of success. We may think that we are being cautious and taking the right course of action, but in fact we could be standing in our own way. Of course, it’s important not to overcompensate and neglect to manage risks properly.
Emotional biases
Emotional biases are when a trader makes decisions that are driven by their feelings rather than logical thought processes. Forex trading can bring out powerful emotions in even the most stoical of characters, because ultimately we are dealing with assets that we all need to secure our survival and comfort.
Therefore it’s not surprising that we are all prone to primal emotions such as fear and greed when we are trading. Wise traders do not try to suppress or deny these emotions, but learn how to recognise them and take action to separate them from their decision making process.
Greed
Naturally, the goal for all traders is to make profits rather than lose money, but when the desire for profit overrides good trading decisions it can have the opposite effect. Traders who view the markets simply as a ‘get rich quick’ opportunity may be particularly vulnerable to greed, causing them to over-leverage or hold onto winning trades for too long.
Greed can also prompt traders to make impulsive decisions and disregard risks, leaving them more exposed to heavy losses.
Fear
As we have seen, fear is an emotion that can lead to loss aversion bias, and it’s the flip side of greed. Instead of actively seeking profitable trades, fear can cause us to be overcautious, exiting trades as soon as they are in profit rather than sticking to our trading plan, or holding on to a losing trade in the hope that the market will turn, even if there is no evidence of this.
Fear can evolve into panic if the markets turn volatile, causing potentially disastrous decisions.
Fear of Missing Out (FOMO)
FOMO is a type of herding behaviour, and it stems from the natural human desire to feel like part of the crowd. Most of us tend to seek safety in numbers, and this is also true when it comes to the forex markets. If the sentiment is running in one direction, it can feel very uncomfortable to tread your own path.
However, chasing market trends rather than making well-informed independent decisions can lead to badly timed trades that get caught up in sudden reversals of fortune.
How to overcome cognitive and emotional biases in forex trading
Reflect on your performance
Over time, forex traders will learn how to recognise and manage some degree of bias and emotional decision making. This often comes with knowledge and experience, and the old saying ‘we learn by our mistakes’ applies here. The key is to reflect on what went wrong in your unsuccessful trades, and question if any of your decisions were biassed or emotion-led.
Assess your performance every few weeks. Keeping a trading journal will help you to do this more accurately. Don’t just write down the factual information about each trade, but also record something of your state of mind and emotions before, during and after the trade. This will help you to identify and challenge any negative behaviours.
Stick to your trading plan
One of the most effective ways to avoid emotion-led decisions is to always stick to your trading plan. This avoids any impulsive behaviour and exposure to unnecessary risks. This is not to say that you should not adjust your trading strategy, but that any changes should be based on logical reasons and back tested on a demo account first.
Stress management
Forex trading can be an emotional rollercoaster, and may even lead to elevated stress levels that make it even more difficult to develop a good trading mindset. Many successful traders use practices such as mindfulness meditation to help clear their minds of mental clutter before they start their day’s trading.
So there you have it!
Understanding the differences (and crossovers) between cognitive and emotional biases can help you to create a stronger trading plan and make more objective decisions. Forex trading psychology is something that most traders will come to master with time and experience.
When we are aware of the traps that our minds can drive us into, we are equipped to navigate the forex markets more effectively.
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