News & Analysis

Cognitive Trading Biases #1 – Loss Aversion

May 14, 2019

As a serious trader, one of the key areas you must work on is to develop an awareness of the way the market affects your mind, and subsequently the decisions you make whilst in a trading situation.

What are trading biases?
People have inbuilt set of belief and value systems that develop over the years through learning and instruction from others and experiences. Many of these developmental factors are outside the trading context but when the trader interacts with the market, these individual natural ways of thinking and feeling become part of decision-making.

Some of these natural in-built responses may not serve you well and are termed ‘cognitive biases’. In many instances in the ‘heat of the action’ when in OPEN trades, these ‘cognitive biases’ take over from your written and planned ‘trading system’ and become the major influence on your market behaviour.

Results that you may produce from your trading can reinforce these in-built biases making them more acute, and so have and ever-increasing influence on what you may do when in the market, until finally they potentially end up destroying the capital and also confidence of the investor.

There are several of these outlined in the “behavioural finance” research literature and we intend over a series of articles to look at the more commonly described of these.

Loss aversion
A loss aversion bias is arguably one of the more common trading cognitive biases. The trader has an overt focus on avoiding taking a loss in a trade.
Obviously, taking a loss, with of course risk management to limit any such loss to a tolerable level (often 2-4% of trading account size) is an accepted reality of trading practice.

However, in those with a loss aversion bias, there are two potential behavioural responses when in an open trade that may be damaging to capital and ultimately sabotage the potential for on-going successful trading outcomes.

1. Stop losses are often moved downwards in a long position (and upwards in a short position) from that originally planned on entry. This is an attempt to regain a losing position with the hope that a price may move back in your desired direction. There may be multiple such “moves” of that stop, each potentially inflicting more damage on capital way beyond any planned maximum risk level. Commonly, there will be an internal dialogue to justify staying in a trade.

2. Conversely, so potentially acute is the fear of losing a profitable trade that such trades are often exited prematurely throwing out of the window any pre-planned profit target or trailing stop system articulated within your trading plan. The internal dialogue we have occasionally heard form traders is “you will never go broke taken a profit”.

So, in practice these two factors result in a reversal of the traditional market wisdom of ‘keeping your losses small and letting your profits run’, in that losses are extended, and profits are cut short.

The basis of such a bias maybe be multi-fold, including:
• Previous losses in investments,
• Lack of education and confidence,
• Over-confidence in your ability beyond competence with a view that a loss in a trade meaning you were “wrong” (an underlying feeling of “I am better than that”),
• Pre-set beliefs about how the market SHOULD move i.e. trading what you think not what you see,
• taking on the “trades of others” without due diligence and perhaps against your plan (e.g. in forums, trading rooms),
• Incorrect position sizing with a small initial trading capital where the effect of trading fees is more acutely felt.

And it can get worse…
One of the MAJOR problems with a loss aversion bias is that it becomes cyclical in its severity, as results continue to fall short of what you had hoped. This is not only with individual trades where losses may become more extended and even smaller than possible profits taken. Desperation may eventually set in, with an obsession to get trading capital back, whilst account value continues to diminish until the trade reaches a point of “no more pain” and leaves the market completely.
This unfortunately has double impacts – not only has there been a loss of a trading capital now, but in many cases have been sufficiently painful that the individual may never again return to trading (so eliminating any potential for future positive investment experiences).

 

What you can do
If this resonates with you, then the purpose of this article is fulfilled, as recognising and “owing” that there is something that needs to be addressed is the VITAL first step in making a change.
Obviously, there are steps you can take to address this (and you MUST). Here are some suggestions:
a. You have a complete trading plan that articulates trading actions once in trades i.e. an exit strategy.
b. Start a journal. Sometimes the very process of formally recording what you are doing helps in doing the right thing more consistently.
c. Press the “reset button” on your trading account. What we mean by this is an acceptance that your trading capital is what it is now. Rather than a mission to regain your initial capital this needs to be replaced by a drive to achieve consistently positive trading results (and including that taking a loss within your tolerable level is a positive outcome). The long-term reality is that through changing this focus as described, addressing the bias through developing that consistency in action, you could give yourself the chance for some sustainable results.
d. Re-align with your trading plan prior to every trading session.
e. Make it a mission to “challenge” your existing plan on at least a 3-monthly basis through gathering an increased weight of evidence that its component parts are working for you as an individual trader. This breeds confidence in actioning a plan, enabling more disciplined trading.
f. There are a couple of ‘unhealthy’ statements that fly around the investment world which you need to check to not become part of your thinking. The first, “do not invest with money you can’t afford to lose” although is from a well-meaning perspective, arguably can contribute to a mindset which gives some sort of permission to lose. The second and more dangerous from a capital perspective is “it is not a loss until you take it”. This is a massive distance away from what is recognised as good trading practice and is completely contradictory to the positive idea that you should take a loss as soon as it hits your tolerable dollar level.
g. Take regular breaks from the market during any session, particularly when trading shorter timeframes, to re-align with purpose and plan.
h. Ensure that you are trading within your level of competence, have a personal trading development plan that outlines your learning for the next quarter.
i. Trade smaller positions until you have evidence of developing good consistent habits that break away from your bias. There are a few different ways to action this, reducing your tolerable risk level significantly e.g. from 3% to 1% of trading account capital, or trading micro-lots rather than mini-lots are a couple of examples.

Finally, be gentle on yourself in terms of your development, biases by nature are usually deeply ingrained and will take some work to replace.

Our education programmes inluding the popular Inner Circle group are there to help you move forward in your trading and our team is there to support 24 hours a day, 5 days a week.