CFD traders are not just competing with each other in the market. They are competing with themselves. Traders can be emotional and irrational, and that can make them their own worst enemies.
Feelings and instincts can provide trading successes, but they are more likely to deliver trading losses unless we learn to be in command of them. This is why understanding trading psychology is critical.
Many CFD traders would like to disconnect themselves from their feelings. Unfortunately, this is not possible, and some feelings may even add to their trading successes. Therefore, it is more useful to learn to understand yourself as a investor, identifying your own strengths and weakness, so that you can decide on a trading style that fits you.
In this section, you will learn about four psychological biases that may negatively have an effect on your trading results, and you will be taught what you can do to overcome them. The biases are:
1. Overconfidence
2. Anchoring
3. Confirmation
4. Loss aversion
1. Overconfidence Bias
Overconfidence bias is an magnified belief in your competence as a investor. Any trader who finds themselves thinking that they know the business inside-out and that they have nothing more to learn and that profits are theirs for the taking, may well suffer from an overconfidence bias.
Risks of Overconfidence
Overconfident traders tend to get themselves into trouble by trading too regularly or by placing exceedingly large trades with the intent of making a killing. It’s not inevitable, but an overconfident investor invites disaster.
Are You Overconfident?
If you want to identify whether you have a tendency to be overconfident, ask yourself, “Have I ever delayed or reversed a decision because I couldn’t believe I was wrong?” Likewise, you could ask yourself, “Have I ever put more on a trade than what I know is really sensible?”
Overcoming Overconfidence
One way to overcome an overconfidence bias is to stick to a strict set of risk management rules. These rules should limit the number of markets you invest in, the number of Contracts for difference you trade at one time, how much you are willing to risk on any one trade and how much of your account are you willing to lose before you take a break from trading and re-evaluate your trading strategy.
2. Anchoring Bias
Anchoring bias is a perception that the future is going to look very similar to the present. When you anchor yourself too closely to the present, you may fail to notice dramatic changes in the offing.
Risks of Anchoring
Anchored traders tend to get themselves into trouble because they wrongly believe that current trends will never end or that companies they’ve always followed will never let them down. Because they are emotionally attached to a CFD, they continue to invest in a way which is not optimal in changed circumstances. With each trade, they lose more money because they are bucking the trend.
Are You Anchoring?
If you want to know if you have any anchoring tendencies then ask yourself, “Have I ever lost money because I couldn’t accept that a trend had ended?” If you have done this, you need to be aware of that tendency.
Overcoming Anchoring
One way to overcome anchoring is to seek a new perspective. Look at different time-frames on your charts. If you usually rely on hourly charts for data, look instead at the daily and weekly charts to examine long-term trends as well as levels of support and resistance. You could also examine shorter-term charts to see if trends are reversing.
Broadening your perspective in this way will help you to avoid anchoring yourself to any one point.
3. Confirmation Bias
Confirmation bias is the habit of only looking for information that supports your beliefs. If you anticipate the price of BHP Billiton (BHP) is going to rise, for example, you will only really take in news and data that bolster your belief.
Dangers of Seeking Confirmation
Traders who pursue confirmation of their beliefs tend to miss warning signs that would otherwise protect them from unnecessary losses. Ultimately, this can only lead to losing money because decisions to buy or sell, or even to do nothing, are being made on false premises.
Do You Seek Confirmation?
To know if you have any confirmation bias tendencies, ask yourself, “How often do I look for signs that I may be wrong in my analysis?” If your answer is rarely or never, you may be a confirmation seeker and you need to actively work to ensure that such a bias never interfere with your better judgment.
Overcoming Confirmation Bias
One way to overcome confirmation bias is to find an individual or group with whom you can talk about your trading. You don’t need somebody who will simply flatter you or continually agree with you. Traders with different views and thoughts will help you to be more vigilant. Sometimes your convictions will only be reinforced by talking with other traders, but at other times, they may force a total and timely rethink.
4. Loss Aversion Bias
Loss aversion bias is based on the theory that losing $1,000 will have a larger impact on you emotionally than gaining $1,000 will. In other words, fear is a more powerful motivator than greed.
Dangers of Loss Aversion
Ironically traders who fear losses are much more likely to hold onto losing positions than traders who are able to accept short-term losses and exit their trades. A reluctance to give up a losing position will not only result in you incurring larger losses but also stop you from finding better trades.
Do You Fear Losses?
If you want to know if you have any loss aversion tendencies, ask yourself, “Have I ever held onto a losing position, beyond the point where I knew I should have quit, because I hoped the trend would reverse and wipe out my losses?” If you have, then you need to be aware of that tendency.
Overcoming Loss Aversion
One way to overcome a loss aversion bias is to trade with automatic stop-loss orders. Many traders trade with just a mental stop-loss that, when it comes to the crunch, they fail to honor. They let their emotions interfere with their better judgment as they try to justify irrational decisions that prevent them from quitting and cutting their losses.
In summary, as soon as you buy a CFD you should set your stop-loss order. It should be physically set, operate automatically, and you should appreciate it.
The Author Ben McGrath is a professional CFD trader trading with Australia’s most innovative CFD broker, IC Markets. Ben has published a number of articles on CFD education including guides and ebooks which you can download for free.
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