Collectively defined as the psychological inclinations and behaviours that can negatively influence trading approaches, decisions and outcomes, bias in trading takes a number of forms. In this article we will outline the most common cognitive biases and provide clear, actionable methods to help traders avoid bias trading.
Cognitive Biases Meaning - What is Bias in Trading?
Cognitive bias refers to a specific set of psychological tendencies and behaviours that can unconsciously and negatively influence trading decisions. Why do cognitive biases exist? They arise from mental shortcuts and emotional “in the moment” reactions which can ultimately impact outcomes.
Cognitive Biases List - Types of Cognitive Bias Traders Should Know
Below we have outlined a list of cognitive biases that are most likely to influence trading behaviour. This will help traders to learn how to identify cognitive biases and avoid their impact.
Confirmation Bias
Confirmation bias trading occurs when individuals are biased in favour of information that confirms their existing beliefs. It suggests that people focus on outcomes in a one-sided way to zoom in on those that support their pre-existing views. This may mean ignoring potentially pertinent information should it disagree with pre-existing predictions or beliefs or go against “gut feeling”.
Anchoring Bias
Anchoring bias in trading refers to when traders over-rely or fixate on a specific reference point or piece of information (the anchor) when making decisions, even if such information is outdated or irrelevant to the current situation. Allowing the anchor to have a disproportionate influence on future decisions may lead to traders over-estimating the value of trades.
Recency Bias
Recency bias takes place when traders focus solely on asset performance in the recent past and ignore historic information or future predictions that do not align with recent outcomes.
Loss Aversion
Another common example of cognitive bias is loss aversion, which occurs when individuals experience the intensity of losses far more deeply than the benefit of the equivalent gains. This can translate to irrational, emotion-led decision-making designed to avoid losses at all costs.
Overconfidence Bias
Overconfidence bias can take a number of forms, typically seeing traders who overestimate the quality of both their abilities and their information, including the most effective times to make strategic decisions.
Examples of Cognitive Biases in Decision Making
Below we have outlined some common practical examples of cognitive bias in real trading situations. These examples demonstrate cognitive bias psychology and the role of cognitive biases in decision making, how biases can distort judgement and how they can have negative impacts on trading outcomes.
Example of Confirmation Bias
A trader believes a stock will rise and only focuses on positive news while ignoring negative reports that the company is struggling and stock value is likely to drop.
Example of Recency Bias
The price of a specific stock has increased suddenly and sharply over the past week and the trader assumes it will keep rising, ignoring its long-term performance history and running the risk of short-sighted decision making.
Example of Loss Aversion
A trader buys shares at $1000 but the price drops to $800. Instead of selling to limit losses, they hold onto the stock, hoping it will rebound, because the pain of realizing the loss feels greater than the rational benefit of closing the trade.
Example of Anchoring
A forex trader sees that EUR/USD recently traded at 1.1000 and anchors on that price, expecting it to return to that point even as new economic data suggests it should move lower. The trader makes decisions based on the old reference point rather than current market conditions.
Example of Overconfidence
A trader correctly predicted last month that stock from a large tech company would rise. They therefore become convinced they have special market knowledge and start taking larger, riskier positions on other stocks without proper analysis, which eventually leads to significant losses when the market moves against them.
How Cognitive Biases Influence Trading Decisions
Bias in trading can have an impact throughout the process, influencing trade entries, exits, risk perception, interpretation of signals, and emotional responses.
Traders may misjudge the ideal entry point due to the influence of confirmation bias, overconfidence or anchoring, making weak signals appear stronger to run the real risk of missing key entry points. When it comes to exiting trade, loss aversion may make traders hold onto losing positions for too long or exit winning trades too early.
Cognitive bias such as confirmation bias can also cause traders to misinterpret signals and ignore key signs, especially during high volatility, and enter/exit trades or change position sizes impulsively based on fear or greed. This can lead to missing out on a potentially winning trade and/or great losses.
Such losses may force traders to significantly deviate away from their trading plan and a disciplined approach due to the negative influence and intense pressure of bias on real-time decision-making.
How To Avoid Cognitive Biases Affecting Your Trading Decisions
While human emotion is an inevitable and important part of effective trading, it’s important to set firm limits to avoid cognitive bias having a negative effect on trading decisions.
Some of the most common signs that show bias is having an influence include impulsive decision-making and entering or exiting trades quickly without any clear thought process. It can also look like inconsistent risk control and a lack of clear risk management structure, or highly emotional trading.
There are a number of practical techniques available to traders seeking to reduce and manage bias, which all effectively work together to support self-discipline and emotional control even during highly volatile periods.
Following a structured trading plan will help to minimise the effects of cognitive bias. This means strict trading rules to avoid impulsive decisions and any risk management tools that work with your strategy, e.g. stop-loss orders. Traders may also wish to develop their own set of trading criteria and rules-based strategies to fit individual risk-reward appetite and trading goals.
Focus on maintaining objective market evaluation across all your trades, including the use of a wide range of reliable information points to inform decisions. Traders should also take the time to educate themselves about historic trends and future predictions for their chosen trades using a variety of reputable channels. This will support an objective approach.
A healthy portfolio will also prioritise diversification to minimise the risk of emotion-led decisions attached to specific trades or instruments. A trading diary can also be beneficial to support consistency, identify any weak spots in strategy, regularly review trades and reduce overreliance on any anchor points.
The most highly regarded brokers offer platforms with integrated support such as educational tools, up-to-date market news to support smart trading. The ActivTrades individual accounts offer access to the best software support via MetaTrader and Trading Central for sharp economic insights, sophisticated trend analysis and clear, actionable trading plans.
Trading Bias in Forex and CFD Markets
The impact of cognitive biases is amplified in leveraged markets because even small price movements can be significant, triggering highly emotional reactions and impulsive decision-making.
Bias in forex trading and CFDs may take the form of highly charged reactions to volatility in the form of anchoring bias, where traders will attach themselves to outdated reference points and dangerously misinterpret price levels with an unrealistic and unfounded hope that the market will return to their desired position even if fundamental and technical realities prove otherwise.
Other cognitive biases may shape dangerous behaviours in the financial markets where the fast-moving and often-volatile nature of trading can mean distorted perceptions and decision-making could have negative effects.
Overconfidence may see traders hold positions for longer than is wise or increase position size based on emotional reasoning rather than logic and fact. Recency bias could see illogical reactions to short-term volatility, incorrectly translating temporary market activity into something more meaningful to make ill-informed trading decisions.
This works in a similar way to confirmation bias where traders can selectively (mis)interpret price actions and key levels, thereby holding trades for longer than advised.
Bias in forex trading needs to be strictly managed with a risk-controlled approach and strong trading structure. Volatility and the fast-paced nature of forex and CFD trading can increase pressure on traders and increase the risk of emotional decisions to magnify negative effects on financial outcomes.
Cognitive Biases in Trading – FAQs
What is Cognitive Bias?
Cognitive bias in trading is a series of unhelpful psychological tendencies and behaviours that encourage traders to misread signals and disrupt a disciplined approach, instead encouraging emotion-led decisions under pressure and compromising outcomes.
What are the Risks of Bias in Trading?
Biases can heavily impact traders and lead to ill-informed decision-making such as emotion-led trading, holding losing positions too long, exiting winning trades too early or deviating away from strict risk management rules designed to protect individual risk appetite. It may also cause traders to misinterpret signals and over/under react to market conditions for a negative impact on trading outcomes.
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