GET Financial Education Series - Futures
Trading Psychology – Lesson 1
You need at least Flash Player 7 to view this website.
Please go to:
http://www.adobe.com
to download the latest version.
"I wish I knew then what I know now." How many times has that thought rolled through your head? Our friend James has probably thought that about his trading career hundreds, if not thousands, of times. You see James started on the wrong foot as a Futures trader. He thought the most important thing to understand was the market. He focused all of his energy trying to learn about the market and didn't spend any time focusing on him self as a trader - and he paid the price.
Futures traders have to not only compete in the Futures market but also against them selves. You have the potential to be a successful Futures trader, but you also have the potential to be your own worst enemy. We, as humans, are naturally emotional. Our egos want to be validated - we want to prove to ourselves that we know what we are doing and that we are capable of taking care of ourselves. We also have a natural instinct to survive.
All of these emotions and instincts can combine to provide us with trading successes every now and then. Much of the time, however, our unchecked emotions get the best of us and lead us to trading losses unless we learn to control them.
Many Futures traders believe it would be ideal if they could completely divorce themselves from their emotions. Unfortunately that is next-to-impossible and some of our emotions may actually help us to improve our trading success. The best thing that you can do for yourself is learn to understand yourself as a trader. Identify your strengths and your weakness, and pick a trading style that is right for you. Don't get too far down the road, like James did, before you spend time learning about you.
In this section you will learn about the following four psychological biases that may be affecting your trading results and what you can do to overcome them:
- Overconfidence bias
- Anchoring bias
- Confirmation bias
- Loss aversion bias
Overconfidence Bias
Overconfidence bias is an over-inflated belief in your skills as a Futures trader. If you ever find yourself thinking to yourself that you have got everything figured out, that you have nothing more to learn and money is yours for the taking in the Futures market, you probably suffer from an overconfidence bias.
Dangers of Overconfidence
Overconfident traders tend to get themselves into trouble by trading too frequently or by placing extremely large trades as they go for the home run. Inevitably, an overconfident trader will end up either trading in and out and in and out of trades - churning the trader's account - or risking too much on the one trade that goes bad and wipes out most of the trader's account.
Are You Overconfident?
If you want to know if you have any overconfidence tendencies then ask yourself "Have I ever jumped right back into a trade I had just been stepped out of not because I saw another entry opportunity but because I couldn't believe I was wrong?"
You can also ask yourself "Have I ever put more on a trade than I normally would because I was just sure this trade was going to be the one?" If you have done either then you need to be aware of those tendencies.
Overcoming Overconfidence
The best way to overcome an overconfidence bias is to establish a strict set of risk-management rules. These rules should at least limit the number of markets you are investing in and the number of Futures contracts that you are trading at one time, how much of your account you are willing to risk on any one trade, and how much of your account you are willing to lose before you take a break from trading to re-evaluate your trading strategy.
By limiting the number of trades you are willing to be in, and the amount of risk that you are willing to take, you can spread your risk out evenly across your portfolio.
Anchoring Bias
Anchoring bias is a propensity to believe that the future is going to look extremely similar to the present - that the status quo will endure. Yet when you anchor yourself too closely to the present you fail to see the dramatic changes that are possible as Futures contracts fluctuate and the underlying fundamentals shift.
Dangers of Anchoring
Anchored traders tend to get themselves into trouble by convincing themselves that the current trend will never end and that a reversal in the fundamental strength of a particular Futures contract is next-to-impossible. Alas they become emotionally attached to the previous trend of a Futures contract and they continue to place trades that go against the evolving current trend. With each trade they lose more and more money because they are bucking the trend.
Are You Anchoring?
If you want to know whether you have any anchoring tendencies then ask yourself "Have I ever lost money because I couldn't accept that the trend had ended?" If you have then you need to be aware of that tendency.
Overcoming Anchoring
The best way to overcome anchoring is to look at multiple timeframes on your charts. If you usually trade on the hourly charts then take a look at the daily and weekly charts every now and then to see where some of the longer-term levels of support and resistance are and what the longer-term trends look like. You should also take a look at the shorter-term charts to see when the shorter-term trends are reversing.
Broadening your perspective will help you avoid anchoring yourself to any one point.
Confirmation Bias
Confirmation bias is a propensity to look only for the information that confirms the beliefs that you already have. If you believe corn Futures are going to go up, for instance, then you will look for the news, the technical indicators and the fundamental factors that support your belief.
Dangers of Seeking Confirmation
Traders who over-actively pursue confirmation of their beliefs tend to miss key warning signs that would normally have protected them from unnecessary losses. In an attempt to build a case for their beliefs some traders miss the facts. Ultimately this leads to them fighting the trend and losing money with each ill-conceived trade.
Do You Seek Confirmation?
If you want to know if you have any confirmation bias tendencies then ask yourself "How often do I look for signs that I may be wrong in my analysis?" If your answer is 'rarely or never' then you may be a confirmation-seeker and you need to be aware of those tendencies.
Overcoming Confirmation Bias
The best way to overcome confirmation bias is to find someone, or a group of people, with whom you can talk about your trading. Hopefully that person or people will not always agree with you. Speaking with traders who have diverse perspectives and ideas will help you to look at your trades from multiple angles. Sometimes talking with other traders will only strengthen your convictions. At other times talking with associates will cause you to change your mind.
Keeping an open mind will help you catch new moves and avoid holding on too long to past beliefs.
Loss Aversion Bias
Loss aversion bias is based on the theory that the pain which is caused by losing $1,000 is greater than the joy that comes from gaining $1,000. In other words fear is a more powerful motivator than greed.
Dangers of Loss Aversion
Traders who fear losses are much more likely to hold onto losing positions than traders who are able to accept short-term losses and move onto other more-profitable trades. Holding onto losing positions jeopardizes the stability of your portfolio by not only incurring losses but by also keeping you out of better trades.
Do You Fear Losses?
If you want to know if you have any loss aversion tendencies then ask yourself "Have I ever held onto a losing trade beyond the point where I knew I should have exited because I hoped the Futures contract would turn around and wipe out my losses?" If you have then you need to be aware of those tendencies.
Overcoming Loss Aversion
The best way to overcome a loss aversion bias is to trade with physically set stop-loss orders. Many traders tell themselves that they will trade with a mental stop-loss i.e. a mentally-noted stop-loss on which they promise themselves they will act should that price ever be reached. All too often, however, traders fail to act on their mental stop-losses. They let their emotions get in the way and they start rationalizing their choice to stay in the trade until it turns around.
As soon as you enter a trade you should set your stop-loss order. Eliminate your emotion.
Now that you've had some time to learn about yourself as a trader you are ready to move on and start learning about the intricacies of the Futures market. But don't forget to take a step back every now and then so that you can re-evaluate how you are doing personally as a trader and make adjustments along the way.
Section Review Question
1. Match the following psychological biases with their definitions:
- Overconfidence bias (1)
- Anchoring bias (2)
- Confirmation bias (3)
- Loss aversion bias (4)
- (2) A propensity to believe that the future will see the perpetuation of the status quo
- (4) A propensity to fear losing money more than to appreciate earning money.
- (1) An over-inflated belief in your skills as a trader
- (3) A propensity to look only for the information that confirms the beliefs that you already have
Overconfidence Bias
