This article explores the cognitive biases in forex trading. The biases discussed in this article can play a significant role in any form of speculative trading and investing, not just forex trading.
Cognitive biases play a major role in how we make trading decisions. Forex trading is one of the most psychologically demanding activities anyone can do to earn money. Due to the fast-paced and often highly leveraged nature of the forex market, it’s much more of an emotional rollercoaster than other types of investing, such as investing in stocks, gold or exchange-traded funds.
Trading involves complex decision making and financial risk management. Not everyone is afflicted by the same cognitive biases equally. One of the biggest hurdles to becoming a successful trader is understanding the biases that affect you most and learning to control them but not ignore them entirely.
Identifying the cognitive biases that weigh on you the most will allow you to understand why you’re feeling a certain way, allowing you to overcome those feelings rationally.
Many experts on the topic of trading psychology claim that psychology plays the biggest role in whether a trader will be successful. While important, technical & fundamental analysis, strategy and risk management play lesser roles. The reason is if you can’t control your emotions and remain objective and rational, it doesn’t matter how good your strategy or analysis is because you will never follow it consistently.
What are cognitive biases?
A cognitive bias is a systematic flaw in how we think. Cognitive biases are present in every decision we face, even the little ones, such as whether to buy a cup of coffee or not. Biases occur when we process information in our environment and affect our decisions and judgments.
Prevalent cognitive biases in forex trading
Dozens of cognitive biases have been defined by psychologists, sociologists and behavioural economists. While some of the biases overlap, the list of biases impacting investment decisions remains lengthy.
Cognitive biases are grouped into categories such as anchoring bias, confirmation bias, egocentric bias, prospect theory, logical fallacy and framing effect. Our biases can impact our interpretation of information or our approach to money.
Sometimes we fixate on irrelevant information while ignoring the relevant. You’d also think that our biases lead us to acts of greed, but more often, they lead us to limit losses rather than chase gains.
The gambler’s fallacy is the feeling that after several unsuccessful trades, your next trade is more likely to be successful. After each unsuccessful trade, you feel the likelihood of the following trade being profitable increases. In reality, the success of your trades has nothing to do with the outcome of your previous trade.
If a trade is unsuccessful, something about your analysis was incorrect. The gambler’s fallacy is detrimental because it causes you to continue trying something that doesn’t work because you feel that the outcome will eventually change by the law of averages.
If the instrument you’re trading is in a clear bullish trend, it doesn’t matter how often you enter short positions; the chances of winning do not increase simply by placing more trades. The forex market doesn’t care how many losing trades you’ve experienced in a row.
The gambler’s fallacy is often illustrated by a repeated coin toss. The outcome of each toss is statistically independent of the previous toss. The probability of getting heads on the first toss is 50%, and the probability of getting heads is still 50%, even if the previous ten tosses were tails.
In contrast to the gambler’s fallacy, the hot-hand fallacy is the belief that someone who experiences a successful outcome, such as a series of profitable trades, will have a greater chance of success in the future. The hot-hand fallacy is essentially the feeling of being on a winning streak and causing heightened confidence.
Traders afflicted by the hot-hand fallacy often feel they will win the next trade simply because they’re on a roll, ignoring the real reasons they’re winning.
House money effect
The house money effect occurs in traders who have generated profit, typically an above-average gain, and are no longer trading with their own money but instead with free money from the house, or broker. Therefore, traders are less risk-conscious because they don’t feel they are risking their money.
The martingale bias builds on top of the gambler’s fallacy, where after each losing trade, the trader doubles their position size to earn enough to recover losses from the previous trade. After each loss, the trader continues to double their position size, so the next profitable trade covers the losses of all previous consecutive losing trades. The strategy only works if the trader eventually wins, but as already established, the likelihood of winning doesn’t increase based on the number of attempts. Following a martingale strategy relies on the same logic as the gambler’s fallacy, where the trader is eventually due a win after a certain number of losses.
Zero-sum thinking perceives situations as a polarised outcome, where one person’s gain would be another’s loss. Many traders cling to the theory that brokers profit from their losses. In reality, the forex market is far more complicated. If a trader loses, it could mean that another trader wins, or a bank on the other side of the world wins. How brokers manage their order flow is complex. In most cases, brokers are not the counterparty to their clients’ trades as they net off exposure between clients or hedge with another broker or use a straight-through-processing execution model.
Sunk cost fallacy
The sunk cost fallacy is when someone doubles down on a losing position or investment. For example, buying 50 shares of PayPal for US$300 per share, then when the price falls to US$100, they buy more shares, essentially throwing good money after bad. An example related to forex trading is continuing to pay swap fees on a position that will likely be stopped out or closed unprofitably.
Loss aversion bias
The loss aversion bias is the tendency to avoid losing more than trying to profit. For example, a trader who feels disappointed about a $100 losing trade meanwhile gaining $300 from other trades. Rather than viewing it as a net profit of $200, they fixate on the $100 loss. Traders suffering from the loss aversion bias focus on preventing losses, rather than achieving gains.
This bias can lead traders to avoid taking risks and not entering trades due to the fear of a negative outcome, known as the status quo bias.
Status quo bias
The status quo bias is the preference to preserve a current situation, which may be favourable, neutral or acceptable and the reluctance to take any actions that would change the current situation, or status quo. The desire to maintain a stable situation and keep things as they are even if they aren’t perfect is known as inertia.
The disposition effect is a prevalent cognitive dissonance among traders and investors which combines characteristics of loss aversion bias and sunk cost fallacy. Traders afflicted by the disposition effect ignore basic risk-to-reward principles by closing profitable trades with negligible gains yet letting losing positions drawdown substantially.
Contagion heuristic bias
The contagion heuristic bias is when a trader avoids a particular trading instrument because they previously had a negative experience, such as large and likely painful losses. For example, if a trader got stopped out and lost several thousand dollars trading BTC/USD may feel that the trading pair or the entire cryptocurrency asset class is cursed.
Hindsight bias is when traders consider positive outcomes, such as a highly profitable trade or a series of profitable trades, resulting from their performance and ability to predict or know what the market is going to do. Meanwhile, they determine that adverse outcomes are the result of unpredictable events.
The confirmation bias is when traders conduct research or analysis with tunnel vision, seeking only information confirming their current point of view and ignoring anything contradictory by labelling it as wrong, outdated, irrelevant, or disinformation. The issue with traders affected by confirmation bias is they feel they have collected substantial evidence confirming their theories, leading to unjustified overconfidence.
The bandwagon effect causes people to ignore their own ideas and follow the market sentiment or specific influencers without necessarily understanding the basis of their decisions. The bandwagon effect is commonly discussed in behavioural finance. It is a primary contributor to price bubbles, like the ones seen in the crypto market towards the end of 2017 and the GameStop affair in early 2021.
The recency bias is when traders assign greater weight to the most recent information and consider older information less relevant. For example, they may disregard an old announcement about the company being investigated for fraud and act on recent news about its earnings rising.
In contrast to the recency bias, anchoring bias is when traders fixate on the first piece of information that piqued their interest in a particular trade setup or investment opportunity. By anchoring to the first piece of information they discovered, they disregard any other potentially important data that may invalidate their theory.