Trading Biases - Loss Aversion - The Biggie.

One of the most common mistakes we all make as traders is to think that we really have 'free-will'. There is a saying which is often quoted by traders - 'You pays your money, you takes your choice'. - The underlying message being that we are totally in charge of our own choices and essentially we have free-will when it comes to decision making. Having been a trader for 25 years, and now as a trading coach, I actually think that this is a dangerous illusion which derails many if not most traders. At the core of this is the belief that traders are affected by a wide range of psychological, philosophical, physiological and sociological affects which influence their ability to think and act rationally when it comes to making their trading decisions.

All people suffer from natural biases and traits. These biases and traits have evolved over millions of years, they are part of our natural make-up and have aided our survival and have helped us thrive in the natural environment. - A few thousand years of domestication versus millions of years of evolution have however not been enough for us to lose these biases and traits which are really our basic instincts. In the trading environment many of these 'basis instincts' can severely impair our ability to read the markets objectively and make good trading decisions. - The first step I implore traders to take in order to help mitigate the destructive affect of biases on their trading is to try and understand these biases, and to become fully aware of them. Below, is a description of what I believe is the main destructive bias to impact one's trading. 

LOSS AVERSION BIAS.
Over the past couple of decades the fields of behavioural economics and finance have shed a huge light on the way we as humans make our decisions in relation to financial matters. Probably the most significant advance in that time was work by Amos Tversky and Daniel Kahneman on 'Prospect Theory' for which Kahneman was awarded the Nobel Prize in Economics in 2002. One of the central elements of this was 'Loss Aversion' bias, which states that people have a psychological tendency to handle equivalent gains and losses differently; a loss almost always feels more painful or detrimental than an equivalent gain.

An example of this would be the pain that losing an amount (say $50) is worse than the equivalent joy from gaining an equivalent amount. This bias manifests itself in all sorts of ways in trading and investing. - Often when a trade starts losing money, there is a tendency for traders to hold on in the hope that the trade will recoup its losses, rather than cutting the losing trade early. In many cases the trade continues losing money, and the trader is faced with much larger losses. This is exasperated by many traders only taking a very small profit (or even cutting out flat) on the occasions the trades do come back. -- This creates a dangerously asymmetric risk/return profile. 

There has been much research into the 'Loss Aversion' bias: In one study it was found that people tend to view losses as having around 2.5 times as much negative impact as a gain of a similar magnitude. In other words a $100 loss has an equivalent impact (in negative terms) as a $250 gain (in positive terms). There is an old trading adage that traders 'should run their profits and cut their losses', often however traders tend to do the opposite, they act in a way that is psychologically comforting to them, but is actually detrimental to their performance. In my early days, quite some years ago, I was told by other traders 'that no one went broke taking a profit', if ever there was poor advice, then that was it! - I have seen far too many people go broke over the years because they took small profits and ran their losses. Though it was only occasionally that those losses would seriously deteriorate, when they did happen they would run and run, and it only has to happen once or twice to completely ruin someone.

Awareness of our tendency towards 'Loss Aversion' is a starting point, though on its own awareness is not going to help overcome the tendency. Traders have to ensure that their strategy and approach to trading is correct and able to offset this as well as many other all destructive biases. - I will talk about this in future articles, however it worth noting what successful traders tend to say around the subject of 'Loss aversion'. Veteran trader and hedge fund manager Peter Lynch is quoted as saying: 'Some stocks go up 20-30 percent and they get rid of it and they hold onto the dogs. And it's sort of like watering the weeds and cutting out the flowers. You want to let the winners run.'

Linkedin Group - Trader Trading & Risk Psychology,

I would just like to advise regular readers of this blog, that I run a Linkedin Group called 'Trader, Trading & Risk Psychology'. 

Group members are able to join discussions, share thoughts, post opinions and distribute articles on the many psychological and behavioural aspects of trading and investing, including

• Trader & Market Psychology.
• Trader Performance & Development.
• Behavioural Finance related to Trading. 

• Sociological aspects of Trading and Markets. 
• The Psychology of Risk.
• The Psychology behind Technical Analysis.
And any other subject within the broad context of trading psychology.
 

I try and keep the group free from commercial/promotional material and spam in order that it can fulfill its objectives as a forum for discussion and learning on the key topics around trading psychology.

I also ask members to keep discussions within the broad context of Trader, Trading & Risk Psychology, and as such away from posting market forecasts and opinions .

The group already has close to 900 members and has been running just a few months. Members come from a wide range of disciplines, including Professional and Private Trading, Research, Analysis, Academia, and many other associated fields. 

To join the group, click on the following the link ; - http://www.linkedin.com/groups/Trader-Trading-Risk-Psychology-3863963?mostPopular=&gid=3863963 ' Then hit the 'Join Group' button.

All are welcome to join: 

Warm regards

Steven Goldstein

3 peaks & a Domed House on the SP500 ??

Over the past few months, I have focused on how the AUDUSD, itself a good proxy for the risk-on v  risk-off trade. - I have been following what appeared to be a rare formation known as a '3 Peaks and a Domed House' (3PDH). This rare formation was the concept of George Lindsey, a brilliant but little known (until very recently) technical analyst who dies in August 1987.

I first touched on the possibility of this 3PDH pattern developing in May of this year on the AUDUSD, the posting can be seen here http://hometraderuk.blogspot.com/2011/05/aud-highly-speculative-view.html

I have maintained regular updates of this, including a posting over the weekend, which suggested a strong risk  that the AUDUSD may be at of close to a final rebound a long and sharp drop.  (Initial stop over 105).

At the end of the last posting, I highlighted a similar pattern on the SP500. - I have decided to update that, with the analysis boosted by having read a superb new book on George Lindsey and his work, written by Ed Carlson. The book is 'George Lindsay and the Art of Technical Analysis', was named 'Stock Traders Almanac' - 'Best Investment Book of the Year'.

The charts below are quite wordy so I will sum the main points, in line with some of the main supporting factors from Ed Carlson's book:

1) The pattern seems to conform (almost to a perfect pattern), it is rare (almost impossible) to get a perfect representation, but this is a pretty good version, with the main exception possibly explained away by one of Lindsey's principles.

2) The pattern suggests we may be close to a serious steep decline taking us rapidly to around 963 (minimum 1010, quite possibly deeper).  

3) The biggest discrepancy between this pattern and the ideal pattern is the wide-ranging consolidation over the past 2 months. This represents the 'roof of the first-floor' on the pattern and typically occurs during the ascending side of the 'Domed House' pattern, not the descending side. On the other hand the ascending side had a shorter correction in Oct 2010 which should have occurred where this one occurred. ( I hope you follow, because I'm struggling and I'm writing it). - Lindsey explains this with his principle of equalization. - [Though I have to give consideration to the possibility that this is a serious departure, and if it does not resolve favourably soon, it may null and void the pattern.]

4) The AUDUSD, which has a very high visible correlation with US equities over the past few years, does not have this discrepency, it has everything in the right order. (With the exception of an irregular top on the 'Domed-House'.

5) My usual Caveat. - Which I am happy to state since I am physically short of the position in AUDUSD, not merely analyzing this, is that as with all chart patterns and price action, it is a probability call and not written into the future.


The first chart shows the SP500 and the idealised pattern. - With desciptions of the various stages.

Below, I have tried to use the 2 day chart to try and explain the anamoly of the 'First-Floor Wall'.

And for good order sake, here is the AUDUSD chart I mentioned, as per Friday's close.

UPDATE - TO AUDUSD - 3 Peak and Domed house Patternn

To update the AUDUSD 3 Peaks and a Domed House pattern.

This AUDUSD has followed the script incredibly well since I first started following it in April/May time. -- Once again we are at a critical juncture. -- 103ish -- If this fails soon in the 103/104 area, it could spell the beginning of a very sharp drop towards .8000 area in next few months. -- I will allow for a short-lived extension to 105, but really any prolonged time over 103/104 I think may start to question this pattern and lead me to thinking that its not going to continue following through.....

Here us my update. With the previous update from September , then the update version at the current price.., - I have also included the SP500 chart below, highlighting that this too has followed a similar evolution to the AUDUSD.

Wham Bham - My two opposing views seem to be reconciling.

Over recent weeks, I have followed 2 trades.

1) The possible top (or temporary top) forming in the Bund (Suggesting a pause in risk aversion).
2) The possible collapse of the AUDUSD towards low 90s/high 80s. (Suggesting risk aversion).

Clearly these two things could not happen together. One had to win out. - The past 2/3 days had suggested that 1) the bund was likely to win. - I now believe we may see a deeper retrace on the bund towards the low 130s. (I favour around 131).   - I also think we may see AUDUSD rally toward 102/103. --- In these volatile conditions, I would not expect either journey to be without some sharp corrections, and possible strong overshoots.

I also think that this may settle the question of how the AUDUSD 3 Peaks pattern was unfolding, (See posting of 12th September), it would favour the pattern now unfolding as Option 1....  - And may set-up a great shorting opportunity around the 102/103 area. ---(Once again with the caveat that this may not turn out to be a true '3 Peaks and DH' pattern.)

FWIW - Ed Carlson, who has just brought out a brilliant book about George Lindsey, the person behind this elusive pattern, says that the '3 Peaks and DH' pattern was intended to be used on equities-only. And although that wouldn't stop one from using it on currencies, it should not to be used in isolation, rather as part of an integrated approach using all of Lindsay's methods. Without those other methods, 3PDh doesn't provide enough info to be certain of its forecast. )

Update on Bund and AUDUSD

Bund never made the break on heavy volume needed, in order to drop sharply... The strong rebound seems to have switched attention away from any drop, as markets seek a FTQ... - If stock markets can hold in, then start rebounding, then this are will still remain in focus.... For now though the analysis on the bund below is invalidated,,, though any topping around 138/139 could still create a triple-top/Head & shoulder type formation.

The short-lived AUDUSD rebound did turn out to be just that, and failure to break over 100 sent this on its continuation lower.  - My original analysis was for a move towards 90 HIgh 80s area, and there seems little to stand in the way of this right now....