Can psychology improve your trading performance? – Guest Editorial
In this research, IG Group takes a close look at emotions and cognitive biases, learned behaviours that work within the subconscious part of the brain and inform decision-making, and their relationship with trading
Becca Catlin is a contributor within the subject of financial services for publicly listed online trading and investments provider IG Group. Her research and publication covers a range of financial markets, risk management and the effects of politics on markets. Becca has also looked at how psychology impacts the decisions that financial professionals make.
The goal of forex trading is simple: to earn a profit. While there are a variety of ways that you can improve your chances of building your capital, one of the most important steps is understanding the impact that psychology has on the way you make decisions.
According to the efficient market hypothesis (EMH), financial markets are completely rational, as market participants always make the most logical decisions, in order to achieve the greatest results.
However, IG Group’s ‘Psychology of Trading’ research showed that despite being correct in their predictions more than 50% of the time, traders tend to lose significantly more money than they win. This is because, in reality, no trader is completely rational all of the time.
We’re all products of our environment, our decisions and our psychology. This means that in order to act rationally, and make the most advantageous decisions, it is vital to understand your mindset and the way it influences your time spent trading financial markets.
There are so many different aspects of the human mind that can influence the decision-making process. But we’re going to take a look at two key aspects of psychology that can help you to improve your forex trading performance, these are:
1. Cognitive biases
1: Cognitive biases
Cognitive biases are learned behaviours that work within the subconscious part of the brain and inform decision-making. They are mental shortcuts that can cause involuntary responses to particular stimuli.
For example, the availability bias is a mental shortcut that prioritises information that is more easily accessed. This can lead to trading based on completely false information, which will increase the risk of failure.
Another example is the loss-aversion bias, which is the desire to avoid loss over and above the desire for greater gain. Of course some awareness of risk is absolutely necessary when it comes to trading, but the loss-aversion bias can actually lead traders to hold on to their losing trades for too long – out of a reluctance to accept any loss – despite this exacerbating the situation.
Often, traders are completely unaware of the cognitive biases that influence them, which is what makes them so damaging to trading performance. By educating yourself on the cognitive biases that can affect you and being proactive about the information you are using in your pre-trade analysis, you can start to limit the influence they have on your trading performance.
There is a famous saying amongst traders that ‘the markets are driven by fear and greed’. Although these are probably the most prevalent emotional influences, there are a lot more emotions that can impact a trader’s performance.
For example, hope can be both a positive and a negative influence. While it is important to maintain a level of optimism when trading, it’s important not to let this go too far. We can see the negative impact that hope can have in the above IG data – it shows that traders hold on to their trades for too long out of hope that they would turn around, which ended up causing them to take on more loss.
A way to improve your trading performance and limit the impact of emotions is to keep a trading diary. This will mean you can be aware of the emotions that you feel, acknowledge them and learn from them.
Behavioural finance is no longer reserved for academics and professional traders, and should form a vital component of every traders’ toolbox.
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