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Some say that mastering the mind is the first step to success. Mental control is the foundation for clarity and balanced decision-making. However, humans are also complex beings with instincts, feelings and sentiments. Our minds are not binary systems and emotions play a very big role in our way of thinking too. So, how does this affect you as a trader? Read on to learn more about trading psychology and biases.
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Trading Psychology 101
Trading psychology refers to those trading decisions that are dictated by emotions and impulses.
We tend to attribute a higher value to logic and rational thinking, particularly in spheres that are characterized by numbers and figures. That is why emotional trading notoriously has a bad reputation. While there can be a place for a well-trained gut feeling in your trading strategy, impulsive decisions should be avoided. It is therefore essential to understand which impulses or biases are more likely to affect you and your trading objectives.
What are the principal types of trading biases?
Doubtlessly, different traders are more likely to be prone to different biases or different bias combinations. However, there are some key biases that are more likely to affect the large majority of traders:
This is probably something that we are all guilty of in trading and in life. In a nutshell, it refers to the situation where traders search for and interpret information in a way that confirms their hypothesis or a trading decision that they might have made.
This type of bias describes those situations where traders sell higher value assets while retaining those that have a lower value. A trader may be prompted by a spur-of-the-moment sentiment to sell assets that have suddenly increased in value. Conversely, a trader may hold on too tightly to assets that plummeted quickly in the hope that their value will increase.
The hindsight bias refers to those instances where traders use the knowledge that they have in the present, to dissect actions from the past. In this scenario, traders may blame themselves for thinking that a particular situation was more obvious than it actually was at the time.
Confidence should be part of every trader’s skill set. However, being too self-assured is just as counterproductive as second-guessing your every trade. Overconfidence can lead you to make trades that do not factor in the bigger picture or analytical research.
This trading phenomenon refers to those instances where traders follow other traders’ decisions, without evaluating the situation independently or analyzing how that affects their trading situation.
The anchoring bias describes the trading scenario where the value of the first asset is considered, as the benchmark with which a trader assesses the value of a second asset. This bias is not limited to trading and it is in fact something that affects many of our purchasing decisions. For instance, if we are seeking to purchase a car, the value of the first option that we review may condition our perception of what constitutes an ‘expensive’ or ‘good value’ model.
How Can You Overcome Trading Biases?
So, if trading biases cannot be eliminated completely, is there anything that we can do to minimize their impact? The short answer is yes.
These are our top recommendations:
1) Understanding which biases are effecting you is the first step to limiting their effects. So, just like it is important to create the optimal trading strategy, it is equally important to identify which situations trigger more emotional responses.
2) Keeping track of your daily steps keeps you committed towards your fitness goals. Similarly, keeping a record of your trades can help you to identify any recurring errors that you may be making and subsequently ensuring that they don’t hinder your trading goals.
3) Making research your best friend is a great way in which to counterbalance those impulsive reflexes.
4) In the same way that research can help you to become a more objective trader, being able to dissect the majority’s actions will help you to make solid decisions that are backed up by logic. Remember that just because everyone is doing something, doesn’t mean that it’s the best course of action for you and your trading goals. So, don’t let FOMO have the upper hand and instead let reason lead the way.
5) Timing is everything in trading as is learning to be objective when it comes to selling. So, be patient with yourself as you learn to walk the fine line between risk taking, sound judgement and that knack for picking exactly the right selling time.
6) Finally, it’s important to understand that you are not only a trader but also a human being who makes mistakes. So, when you let emotions get the better of you, think of the valuable lessons that you can glean from the experience.
Learn more about trading and how to trade over at our education section.