One of the biggest enemies that any trader has is recency bias. This is the phenomenon that occurs when we pay more attention to things that have happened recently than to things that have happened in the past. This is natural human behavior, but it leads to bad trading decisions.
A simple example of this is when a technical trader spots a new pattern, and then uses this as the sole criterion for making a trade. When they do this, they end up ignoring longer-term market behavior and as a result have a myopic – and often incorrect – view of how the trade is likely to unfold. Fundamental traders can also fall afoul of the same fault, trading on the latest economic news rather than looking at it in the larger context of historical macroeconomic performance.
Guest post by Mihai Milea of XTB UK
An even simpler example is when a trader is on a losing streak. Even if they have profited on 30 of their last 40 trades, they will have a jaundiced view – and make emotional mistakes – if they have lost the last 6. On the other hand, a trader who has only won on 10 of their last 40 trades will still be happy if the last 4 all went in the right direction – in this case, they are likely to become overconfident and not do their due diligence going forward, resulting in further losses.
Trade journals are key
To maintain a 10,000 foot view of your trading history, it is important to keep a trade journal. This allows you to step back from recent losses – or profits – to take a dispassionate view of what is working in your trading and what isn’t. This is the only way to really judge your trading performance accurately and to spot where you need to improve – and what you should try again because it seems to lead to success.
Stick to your trade plan
To eliminate emotion and recency bias, you should also have a written checklist of criteria that any trade needs to meet before you enter into it. This will help you to avoid the trap of overconfidence, and also help you to overcome hesitation if you are on a losing streak.
Understand your emotional state
Finally, no matter how hard you try to take a deliberate and measured approach to trading, your emotional state can still derail you – and this is most evident with recency bias. Take a step back and look at yourself on a regular basis, and decide whether or not your emotions are getting the best of you. If they are, make a concerted effort to go back over your trading history, in order to gain a more objective view of how you are performing.
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