Breaking behavioural biases for better trading.
Behavioural biases can mean traders act against their own best interests. By being aware of these behaviours you can take advantage of a range of approaches and automated tools to limit losses.
IN A FEW WORDS
Trading behaviour Trading biases Managing trading risk What is stop loss
3 min reading
“The investor’s chief problem—and even his worst enemy—is likely to be himself.” – Benjamin Graham.
What are agricultural commodities?
While many traders are seduced by finding the next winning trade, in reality, not losing money is just as important. The problem is that humans often aren’t naturally good at managing risk we get caught up in the excitement of a winning trade, or panic when a trade goes against us.
Awareness is the first step
For example, many traders can be prone to over-confidence: a few good deals can give them a misplaced sense of infallibility. At the same time, many exhibit loss aversion, whereby they don’t sell poorly performing trades in the expectation that it will come right, even in the face of mounting evidence to the contrary. This can see them cutting their winning positions and running their losing positions.
Self-attribution bias sees traders blame external factors for losses but take personal credit for any gains. Traders are also inclined to believe that activity is good, while studies suggest that those who over-trade tend to underperform the market.
Just understanding these potential biases will help manage risk. With any trade it is good to have a clear idea of the parameters:
- What are your expectations of profit and your tolerance for loss?
- What will make you revise your view?
- Can you take a step back from your trading strategy and be objective about why you hold each trade?
Automated buying and selling
Managing these biases isn’t always easy to do in practice. If a trade is on a winning streak, it’s easy to get carried away with how much you might make. Equally, there is always a temptation to bet more and more in an attempt to claw back losses. Traders often need to make quick decisions and it can be difficult to do so dispassionately.
Trading platforms usually allow you to put automated buy or sell orders in place to limit risk.
A market order is an order to buy or sell a security immediately, while these ‘limit’ orders are orders to buy or sell in the future when certain conditions are met. They can add to the cost of trading, but are usually only a tiny fraction of the trading margin and, used properly, can save you a lot of money over time. Automated orders also mean that you’re not having to make decisions in the heat of the moment, which can lead to mistakes.
A stop loss is a command to sell a security instantly if it hits a certain price. This can impose discipline on trading. A trader may set the stop loss price when losses on a trade hit, say, 10% or 20% of the original stake. There will always be a balance to be struck between allowing a trade some volatility and guarding against losses – the trader will need to decide where that balance lies. It makes the decision-making process unemotional: identifying key price risk areas in advance can also be useful to hone risk management skills.
This is also an automated sell order, but this time when the price has hit a specific level on the upside. While received wisdom is to ‘run your winners’ - allowing a winning trade to keep going as long as possible - traders can get greedy. Almost no trade keeps going up indefinitely and it is useful to know when to crystalise profits. It is worth remembering that you don’t have to sell the whole stake. It is possible to take partial profits all the way up.
Automated buy orders
These would be used to make sure you don’t miss an attractive buying opportunity and you would need to decide on the right price. They can also be used when selling short to make sure you’re not left with uncapped losses. Shorting is always more perilous – the share price can theoretically rise indefinitely, while it can only fall to zero.
Asset prices tend to have pressure points. Traders will often place stop losses at certain round numbers and opportunistic algorithms will then take advantage. There can also be behavioural traps in terms of where you place your automatic trades. It pays to watch potential patterns and place orders accordingly.
Risk management is your friend and could make far more difference to your trading profits than you may realise. The Fineco platform has the tools in place to help you.
studies suggest that those who over-trade tend to underperform the market: toptal.com/finance/financial-analysts/investor-psychology-behavioral-biases.
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