Forex Trading Widsom: The Biased Trader

DailyFX.com –

Talking Points:

• Why we need a bias
• How stimulus shapes our bias
• Anchor your stimulus in probabilities

What is the biggest obstacle a trader needs to overcome to be successful?

If you asked this question to experienced traders, they would suggest the biggest obstacle is between the trader’s ears…their mind. Our mind will play games with us when we have real money on the line.

The same experienced traders would suggest the way around this obstacle, would be to relax, have a trading plan, and stick to the plan.

Let’s be real for a moment…that is a lot easier said than done!

We know we should stick to the plan, but our mind plays games with us on why we should deviate from the plan. “This time it is different” is a common thought our mind uses to get us to deviate. It is paradoxical in that we likely have to play mind games with ourselves to protect ourselves from our own mind games!

Today, I would like to explain, on a different level, what a lesser experienced trader could do to help them through this paradox. It may come as a surprise, but you need to bias your trades. Bias your trades against their probabilities rather than on a limited number of outcomes.

First, let’s build a case for why a bias is needed, and then we’ll discuss how to anchor them.

Why We Need a Bias

The end goal we are striving towards is making good decisions with real money on the line. There are so many decisions a trader makes on each trade that it can be overwhelming. For example, a trader needs to determine what market to trade, when to get in, how long to hold the trade, when to get out, and what trade size. There are many other decisions that enter in as well such as, do I move my stop loss, do I take partial profits and scale out (there are many more choices to be made, but you get the point).

This long list of decisions to make will have some pros and cons for each decision. Neuroscientist Antonio Damasio describes that in order to make decisions, there is an element of emotion involved. He saw patients with all faculties for rational behavior in tact – attention, memory, and logic. However, brain damage removed the patient’s ability to experience feelings and it robbed him of making successful decisions day to day. (Descartes’ Error: Emotion, Reason, and the Human Brain [Antonio Damasio])

In essence, it is our bias towards the pros and cons which impacts the decision we ultimately make.

To illustrate, if you were going to decide whether to go to the game tonight, you might think it would be fun and you get to hang out with friends and eat a good hot dog. But, that fun comes at the cost of tickets, parking, and time away from doing something else. If a person was not biased in their decision making, then they would not be able to arrive at a decision because of the competing pros and cons of going to the game.

If you just hurt your leg, the thought of walking a half mile in the parking lot then going up and down stadium stairs would bias your decision towards staying home. In the end, your decision making is influenced by feelings and a bias.

We Need a Stimulus to Shape Our Bias

Sometimes, the stimulus is created even if we can’t describe it. Damasio performed an experiment where he asked subjects to turn over cards that were placed in four different stacks. The stacks were rigged with two of the stacks producing gains (in play money) and two stacks producing losses. After nearly ten turns, the subjects starting showing physical reactions when reaching for a losing deck. After nearly fifty turns, the subjects could articulate a hunch about two of the four stacks being riskier.

When the experiment was replicated on brain damaged patients, none of the typical reactions occurred.

Absent the stimulus to produce a positive or negative feeling, there was nothing to overwhelmingly influence the brain damaged patients decision making.

In the game example above, there were reasons to go and reasons to stay home. The ultimate decision derives from an overwhelming stimulus either by experiencing good times or because of the desire to save money for a better time in the future. Absent the overwhelming stimulus, we get stuck unable to make a decision.

In the trading world, a newer trader often gets hung between the potential for profit and the possibility of loss. They don’t have enough experience to produce and overwhelming emotion about the trade set up. They in essence, lack the confidence and ability to ‘control’ a positive outcome and wind up freezing with indecisiveness. As a result, they let other things improperly anchor that emotion for them like their recent demo results.

Newer traders tend to rely solely on outcomes to develop their perceptions. The problem with the outcomes is that even though some of those trades may have been profitable, they are likely riskier over the long run.

Suggested Reading: What is a Good Win Ratio?

Bias your trades with probabilities

On the other hand, a more experienced trader will weigh those outcomes against their prevailing probabilities. They would have gained enough experience to know that some trades will win and some will lose and that they are looking at the larger collection of trades to determine profit or loss.

Suggested Reading: The First of Ten Trades

Experienced traders will try to down play the results of the most recent trade because they are trading a strategy. Each individual trade is just a small moving part of the much larger strategy.

Learn about other higher probability behaviors through DailyFX’s 45 page Traits of Successful Traders research guide. Learn four traits used by traders to give themselves an edge. (Registration required to download the guide.)

Newer traders, therefore, need to gain an impactful experience to properly begin weighing outcomes against probabilities. That experience is gained by trading a live account, even if it is in the smallest trade size possible.

Notice in the “stack of cards” experiment how ten turns needed to be played before an internal bias could be created. Then, another 40 turns needed to be played before the subjects could begin to verbalize what they were experiencing.

Many newer traders make the mistake of allowing themselves to be misguided by following solely their outcomes. Those misguided feelings lead to other poor trading decisions (over confidence, over leveraging) that lead to large losses.

After a series of large losses, the trader then decides the market is too random and cannot be timed.

By understanding how experienced traders bias their trades using the Traits of Successful Traders (TOST), a newer trader can begin immediately. Simply practice in a demo account, and then place at least 50 live trades in small sizes while adhering to the TOST guide. This will allow the trader to begin anchoring their results together with probabilities.

—Written by Jeremy Wagner, Head Trading Instructor, DailyFX EDU

To learn more about implementing TOST, join DailyFX’s free Forex Fast Track course. The series of four fast track webinars are rooted in TOST and how to effectively implement those traits.

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Source: Forex Trading Widsom: The Biased Trader