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Trading Psychology Part 3

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Your success or failure in trading depends on your emotions. Having a good trading system is not enough. You may have an exellent system, but if you feel upset, anger, arrogant, your account is sure to suffer. According to conventional financial theory, participants are, for the most part, rational wealth maximizers. However, there are many examples where emotion and psychology influence our financial decisions, causing us to behave in irrational ways. Behavioral fianance is a new field that combines behavioral and cognitive psychological theory with conventional economics to provide explanations for why people make irrational financial decisions. This topic will give you an edge to understand the underlying reasons and bias that cause people behave against their best interests. Hence, you may have some useful tips applying to your trading style.

Gambler's Fallacy


It is a tendency that an individual believes that a random event is less likely to happen following an event or a series of events. This thinking is incorrect because past events do not change the probability the certain event will happen in the future. For example, a person toss a series of 10 coin flips with the heads side in a row. Then he might predict the next coin flip is more likely to land with the tail side. This forecast is incorrect because each coin flip is an independent event, which means that all previous flips have no impact on future flips. In addition, the probability of a fair coin turning up tail side is always 50%. In trading, you should not go short because you guess a currency pair has too may days in green. For example, the GBP/JPY had 12 days in green then do not fight the trend.

Representativeness


People usually assume shares in a high profile, well managed company is a good investment. In addition, they put too much weight on recent experience. It is called Law of small numbers. Hence, they assume past performance is an indication of future performance. For instance, you meet an trader with high performance during recent months. Then you think he is a genius and you might invest some money in his fund. This is a common mistake. Nothing can guarantee his result in the future. This is true for your own trading. You need to avoid overconfidence after a series of win. The next trade is unknown. To avoid representativeness, you need to track long history performance to evaluate the average return per year, maximum drawn down, profit factor, etc. Then you decide which fund or trading style is suitable for yourself.