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Trading Psychology Part 4

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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.

Framing


People tend to focus on the behavior of individual investment. Then they often overreact when one of those investments goes to loss. The narrow framing tends to increase investor sensitivity to loss. As a result, this tendency implies overreaction behavior. To avoid this behavior, investors should evaluate their performance at the aggregate level with a wider frame, even accept short term losses. In FX trading, investors need to look at charts with long run time frame weekly, daily first to determine the trend. And they have to accept short term losses in the short run before the currency pair goes on the right way. The below example describes that EUR/USD daily chart is going up but 1h chart is likely to go down. That is the reason why you need to loot at wider time frames before accessing shorter frames.

Conservatism Bias


This tendency desribes the idea of the decision maker clings to an initial judgement despite new contradictory information. For example, investors assume that a high profile company is a good investment. Then they may be slow to adjust their view of the company even after the company's profitability decreases. In FX trading, investores are slow to change their view even after the currency pair has a sign to change its trend due to fundamental shift. They clings to their original view. If you insist your view without using stoploss, your account is sure to suffer. To avoid conservatism bias, you need to study both supporting and contradictory information. Of course, you need to accept the cost if you are wrong. Always trade with stoploss order.