To understand how to be the best trader in forex, you also have to understand the ways other traders think.
Investing is a profession as much about people as it is about money, and this is even the case in forex trading which described in the most laconic terms possible is about using money to buy money.
Whilst knowledge, information processing and portfolio management are critical skills to a successful trader, mindset, mentality and psychology are also critical as well, especially since with forex funding, traders are working with substantial sums of money.
At that level, a strong mental game is vital to maintain your positions and avoid being swayed by the two great emotions that affect the market more than any other; fear and greed can leave us vulnerable to make mistakes, fall back on our biased assumptions and potentially lose a lot of money.
However, one of the golden rules of psychology is that being aware of one’s own biases and mental gaps takes away a lot of their effect and is the first giant leap towards nullifying their effects.
To explain and demonstrate why this is so often the case, here are some examples of typical mental shortcuts, biases, logical fallacies and mistakes even the best traders sometimes make, and in explaining why we have them, we can become more aware of when they could affect potential gains.
Unlearning Economic Dogma
Part of the reason why it can be so difficult for traders and other economic minds to admit to a universal aspect of humanity is that nearly a century of economic theory relied on the concept of perfect rationality.
The concept of homo economicus (economic man) has been part of many economic models that attempt to explain market behaviour and was initially devised by utilitarian philosopher John Stuart Mill.
The core idea as used in economics as opposed to moral philosophy is that all people who engage with financial markets have the capacity for perfect rationality and also operate under a principle of narrow self-interest.
In other words, economic models for a century were designed with the assumption that everyone who used them made decisions entirely rationally with perfect access and understanding of all available market information and consistent, selfish goals to make the most of each sale.
This is the basis of a school of trading known as “traditional finance”, particularly concepts such as the efficient-market hypothesis which rely heavily on the economic man theory to ensure that all assets are traded at their market value and thus never have an inflated value nor are undervalued.
By contrast, the school of behavioural finance which started to gain a significant foothold in economy theory by the 1990s posited that all investors have biases and other psychological influences that affect their decision-making.
This can be directly at the trading floor level, but also indirectly through the assumptions used to construct trading plans and computerised investment models, which may not be made with perfect rationality and narrow self-interest either.
Understanding this allows a trader the space to examine when their biases and assumptions might be getting in the way of potentially successful trades, as well as parsing between unusual market behaviour and irrational trading moves.
It also gives many traders a greater appreciation of planning and seeing appropriate stop-loss orders to minimise losses and ensure a consistent level of profit.
The Power Of Stress
At the centre of so many irrational market moves and why greed and fear can take hold of even the best trader is the fact that trading is often exceptionally stressful, and this stress can halve short-term and long-term effects on your health and decision-making acumen.
This is not a case of simply being unable to handle stress and pressure either; stress has physical effects on the entire body beyond simple dumps of cortisol and adrenaline, some of which can have long-term and particularly damaging repercussions.
Of course, in the short term, stress can be a potentially beneficial reaction. It generates our “flight-or-fight” reaction, speeds up our heart rate and allows us to react and respond with a greater alertness than we might have otherwise.
However, it also blocks our ability to slow down and think more flexibly, instead rushing into trades and investing based on what we know, which tends to be guided by core emotions such as fear and greed.
If you feel stress getting too much, or are trading in a somewhat chaotic market that increases your sense of uncertainty and by extension stress, the most prudent option is to step away from the terminal and try to relax and reduce that stress.
Exercise can be an excellent stress reliever, as can mindfulness meditation, as both centre people in the moment during times and jobs where it can be easy to dwell on the past or fear an uncertain future.
What Are Some Examples Of Biases And Fallacies?
Knowledge is power, and the best way to understand how to manage and avoid potential logic gaps is to see some examples of biases and how they shift thinking in practice.
These kinds of logic gaps not only directly affect trading decisions through the use and misapplication of mental shortcuts, but they also can affect wider trading behaviour such as how a trading plan is devised and reactions to the unexpected.
One of the most commonly cited examples of a cognitive bias that applies to trading is loss aversion, and indeed Daniel Kahneman and Amos Tvesky’s prospect theory explores at length how it affects market decisions.
Loss aversion is the tendency to emotionally and psychologically be affected more by losses than an equivalent gain, with trading behaviour often altering to reduce the risk of any loss even at the expense of potentially substantial profits that still rest within acceptable risk tolerances.
Mr Kahneman and Mr Tvesky found through their study that on average, losses hurt over twice as much (2.25 times on average) as gains feel good to investors.
This means that a trader would need to make more than double on their investment than they risk losing to take the chance, something that particularly affects forex trading due to its often-slim margins.
Another example of a mental shortcut that can lead to irrational trading behaviour is the concept of reference anchoring, which is where a trader will often set their minimum selling point at an arbitrary target (often what they paid for it) and may either sell early once it makes a small gain or avoid selling if it makes a loss.
Where this causes problems is that it does not factor in the overall trajectory of the market. In some cases selling for a small loss is the desirable option if the whole market is down, whilst
selling early before reaching your stop-loss tolerance might cause one to miss out on a surging currency pair.
However, the latter option, despite being more irrational, is more satisfying to traders because it avoids losses and is higher than what they paid.
Another common mental shortcut is herd mentality, where people follow the majority of the market based on the idea of collective wisdom. If everyone is making the same move it must be the correct one.
If traditional financial theory was correct, then the majority of traders would be making the most logical choice, but as we have seen many times, the masses are not always correct when it comes to financial decisions, and sometimes the herd can end up seeing their investments plummet.
In stressful situations, people tend to stick to what they know, and this can often lead to familiarity bias, where people invest in currency pairs they are most familiar with, such as UK traders having a portfolio centred around the pound sterling.
Whilst being knowledgeable about the commodities you are trading is typically good, it can lead to a lack of diversification in your investments, something that can end disastrously if, for example, most of your investments rest on the pound increasing its value.
There are also fallacies that typically come about due to a misapplication of probability and attempts to develop patterns based on previous results. Whilst previous information can tell us a lot about future results, each trading decision should be made on its own merits and not based on previous trading results.
This leads to both the gambler’s fallacy and the hot hand fallacy, two often connected and influential biases that can destroy a portfolio if left unchecked.
The gambler’s fallacy is the idea that something that has happened is less likely to happen again in situations where a previous result has no bearing on an upcoming one.
The most infamous example of this took place on 18th August 1913, when a roulette wheel landed on black 26 times in a row at a casino in Monte Carlo, Monaco.
In investing, the gambler’s fallacy is when after dealing with a string of losing trades, a trader decides to make a risky or ill-advised trade because at some point their luck has to turn around.
By contrast, the hot hand fallacy is the opposite idea that a string of successes will continue, which leads to riskier and larger investments until an inevitable loss.