What is 'rationality' in trading?

Rationality in trading is the ability to make choices that will result in the best possible outcome given the information available. Rational decisions aim to maximise an advantage, while minimising any losses.

Although rationality is all about seeking the optimal outcome, studies have been quick to point out that this doesn't always mean making money – a rational decision can involve minimising losses and even accepting a loss.₁

How can traders become rational?

A common way to improve rational decision-making is through a demo account, which enables you to practise trading and test your strategy without risking any capital.

A demo account can help you to familiarise yourself with market dynamics so that when you start to trade using your own money, you won't be overwhelmed by feelings of fear – enabling you to trade in a more rational way.

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What does 'decisiveness' mean in trading?

Decisiveness in trading is the ability to identify opportunities and act efficiently – this includes making decisions about when to enter and exit trades, assimilating new information into a plan and learning from mistakes.

According IG's survey, 27% of investors 'go with their gut' when making decisions about money. However, research by Gollwitzer showed that ill-informed decisions can lead to excessive risk, because they cause a disparity between a plan and its execution₁. Although it is important to act quickly, it is also important to make sure you have taken all the available information into account to give yourself the best chance of making rational decisions.

How can traders become decisive?

The best way to become decisive is to create a suitable trading strategy that outlines what you will need to see in your technical and fundamental analysis before you open a trade. This enables you to identify suitable entry and exit points before you start trading and ensures that your decisions have a solid foundation in historical data and trends, rather than 'gut feeling'.

If you focus on technical analysis, you'll use indicators to study signals and trends. The data they give off is then used to establish entry and exit points, and where to place stops and limits. Popular technical analysis tools include Fibonacci retracements, moving averages and Bollinger bands. If you choose to use fundamental analysis you'll evaluate macroeconomic data, company financial reports and the news to establish how and when to trade.

If you aren't confident in your ability to stick to your pre-made decisions, you could consider automating your trading strategy. This is where you would set the parameters of your order and allow an algorithm to analyse the market and respond to opportunities as they arise.

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What is confidence in trading?

Confidence in trading is trust in one's own abilities and knowledge. Every trader requires a certain level of confidence so that they can identify and act on opportunities, as well as bounce back after a losing streak.

IG's survey found that investors and traders had higher levels of confidence when it comes to financial decision-making than non-investors. However, there is a difference between confidence and over-confidence, which is an unrealistic view of one's abilities. Research by Dorn and Huberman found that, of the 1345 German investors they surveyed, those who considered themselves more knowledgeable than average were actually more prone to excessively buy and sell assets₁. This habit can lead to further losses and decisions that are based on fear rather than research.

All traders will experience losses, but a confident trader will know that everyone has bad days and that sets them apart is learning how to minimise these losses.

How can traders become confident?

The best way to become a confident trader is by trading using a demo account, which enables you to test your trading strategy in a risk-free environment using virtual funds. Alternatively, you could opt to backtest your trading strategy by taking a chunk of real data from a selection of markets and running your strategy against it.

Both methods enable you to build up confidence in how your strategy would perform, without using any actual capital. However, it's important to remember that neither provides a perfect reflection of a live market, as they won't always take factors such as liquidity into account when executing your trades.

To avoid being overconfident, just remember that there is never an end to how much you can learn and the experience you can develop. Even the most successful traders can learn more and develop their strategy further.

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What is 'patience' in trading?

Patience is the ability of a trader to wait for signals that indicate that it is time to enter or exit the market. This could include making decisions that delay instant gratification in the hope of a future benefit.

IG's survey found that 66% of participants trade or invest as they recognise it will provide a better return than cash savings. But if a trader doesn't have the discipline to stick to their trading plan and the patience to wait for the correct market conditions, it can have a huge impact on their long-term goals.

A study by Freeman-Shor found that only 21% of the stock investments analysed realised a return of over 100%, even though many of the shares went up by significantly more over time₁. This was because very few individuals had the patience to wait for the trend to run, preferring to sell for a much smaller profit than risk losing what they had made.

Although it is unreasonable for traders to expect huge returns from every trade, it is important not to 'snatch profits' in small amounts out of fear or loss aversion. Although this might give a sense of instant gratification, there is the risk of losing out on a much larger gain.

How can traders become patient?

To develop patience, it is important to understand that your desired market movement might not happen straight away or at all. Building a suitable risk management strategy is a great way of managing impatience – this should include setting stop-losses and limit orders.

For example, a trailing stop-loss will automatically follow your position by a certain amount of points. This enables you to lock in your profit if the market moves in your favour, but it will remain in place if the market falls – closing out your position if the market moves against you.

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The Art of Execution: How the World's Best Investors Get It Wrong and Still Make Millions, Lee Freeman-Shor (2015)

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What does 'discipline' mean in trading?

Discipline in trading is the practice of sticking to strategies, avoiding holding onto losing trades and taking profit at the right time. It is an attribute that regulates attention, emotional responses and decision making.

Without discipline, traders risk letting their emotions cloud their judgement, which could lead to large losses. In fact, a study by Lock and Mann found that the median holding time for losses is over four times as long as the holding time for gains, and this lack of discipline makes a trader less likely to be successful in the future.

How can traders become disciplined?

The best way to become disciplined is by creating a trading plan and outlining a risk-to-reward ratio – this compares the amount of money you are risking to the potential gain to your position. In theory, with the right ratio, you could lose more than you win, and still make a profit. For example, if your ratio was 1:3, you would only need to be successful on three out of ten trades to have an overall profit.

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How can 'gambler's fallacy' affect traders?

Gambler's fallacy in trading is the tendency of an individual to think that a trade will go a certain way based on past events – even though there is no substantive evidence to support the trader's thinking. The term originated from the inclination of gamblers to think that a bet might go a certain way based on previous results.

When applied to trading, a study by Rakesh found that 55% of investors who took part believed that a random event would occur again just because it had occurred in the past₁. This could cause a trader to base a decision on previous analysis, even when the indicators which had worked for them in the past are no longer relevant or helpful given the current market movements.

How can traders prevent gambler's fallacy?

You can minimise the risk of gambler's fallacy affecting your trading by basing your decisions on up-to-date analysis and setting a clear risk-to-reward ratio – which compares the potential loss to the potential gain for each trade you open. This can help you to think clearly and assess each situation on its own merits, and will also minimise the effects of any losses on the overall value of your trading account.

An example of a risk-to-reward ratio would be if you placed a guaranteed stop on a trade, capping your maximum loss at £100, along with a limit giving you the potential to realise a £300 profit. In this scenario, the risk-to-reward ratio would be 1:3.

With a 1:3 ratio, you could generate a profit by only being right 30% of the time. This is because if you placed ten trades risking a maximum of £100 each, you would lose £700 from your seven losses, but you would make £900 from your three gains. Of course, if you're taking on less risk for a greater potential reward, it's likely the market will have to move further in your favour to reach your maximum profit, than it will to hit your maximum loss.

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How does 'loss aversion bias' affect traders?

Loss aversion bias is a preference for avoiding losses over acquiring the equivalent gains. It implies that the fear of a loss is greater than the pleasure of a gain.

Research by Odean looked at 10,000 trading accounts held between 1987 to 1993, and found that individuals have a tendency to hold on to losing positions for a much longer period of time than winning trades, out of a fear of realising a loss.₁

How can traders prevent loss aversion bias?

A key step in preventing loss aversion bias is acknowledging that it exists. When you start to create a trading plan, it is important to consider how much you are willing to lose as well as how much you want to gain. And once you have established your trading plan, it is important that you have the discipline to stick to it to avoid taking unnecessary losses.

One way of doing this is by setting a suitable risk-to-reward ratio, which compares your capital at risk to the amount you stand to gain. For example, if you set a ratio of 1:3, then you'd only need to profit on three out of ten trades to have an overall profit. The correct risk-to-reward ratio could ensure that your gains are always at least as large as any potential losses, giving you the confidence to overcome loss aversion bias.

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How can 'confirmation bias' affect traders?

Confirmation bias is the tendency for traders to search for, and put greater weight behind, information that confirms their pre-existing beliefs or predictions. This could mean that a trader disregards negative news about an asset because they believe that the good outweighs the bad – even though this may not be the case.

Confirmation bias is linked to overconfidence, which can lead to poor decision-making and overtrading. A study by Park, Bin Gu, Kumar and Raghunathan found that traders with stronger confirmation bias are likely to exhibit greater levels of overconfidence and trade more frequently. This can lead to them obtaining lower profits because they might lose more often. IG's survey revealed that 29% of traders and investors go with their gut when making decisions – a sure sign of overconfidence.

How can traders prevent confirmation bias?

Confirmation bias can be prevented by carrying out your own analysis – whether this is technical or fundamental – and trusting that it is correct, even if it clashes with earlier predictions or preconceptions.

Technical and fundamental analysis can be a great way for you to identify whether you should be buying or selling a particular asset – for example, overvalued stocks or undervalued stock. Analysis can confirm the true value of an asset in a more accurate and definitive way when compared to say, preconceived biases or gut feelings.

It could even benefit you to actively seek out information that clashes with your preconceptions because this could counteract your confirmation bias – forcing you to think about each trade in terms of its own merits.

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How does framing bias affect traders?

Framing bias occurs when traders make trading decisions based on how data is ‘framed’, presented, or disseminated, instead of the facts and figures themselves.

Phrasing, diction, and selective data presentation are three factors that could potentially affect or influence a trader’s mentality and feelings towards a particular event or asset.

Consider the following sentences:

1: In Q4, our revenue came in at $420 million, up 5% from $400 million during the same quarter a year ago.

2: In Q4, our revenue rose 20% from the previous quarter to $420 million.

The first statement reports the company’s earnings in a standard year-on-year reporting manner, while the second statement presents and frames the earnings with data that make the earnings look better through a quarterly comparison rather than a yearly comparison.

How can traders prevent framing bias?

One way traders can prevent framing bias is to try rephrasing or rewording the sentences to contain facts and figures that they deem more appropriate and useful for analysing a company or an asset’s performance.

For example, they can rephrase and simplify the above earnings data to: ‘Company X’s revenue for Q4 this year was $20 million higher than Q4 last year, and $70 million higher than Q3 this year.’

The new phrase reframes and reduces the psychological effect that any potential spin in data reporting might have on a trader.

Another way to lessen the framing effect is to research a particular topic or asset more thoroughly, as this would ensure that they would be more sensitive to any incidence of data framing.

How does 'hindsight bias' affect traders?

Hindsight bias in trading is the tendency for individuals to express that they 'knew it all along', once they know the answer to a question or the outcome of an event that was previously uncertain.

The consequence of hindsight bias is that it often leads to a false sense of confidence. IG's survey found that up to 55% of traders believe that they are very disciplined when trading – however, this is a dangerous mindset because biases can creep in and lead to irrational trading decisions.

A study by Biais and Weber found that those who exhibited the hindsight bias failed to remember how uncertain they had really been before they made their decisions. This means that they may have been inefficient in making choices regarding risk management. From the 85 investment bankers surveyed, all were found to exhibit hindsight bias.₁

How can traders prevent hindsight bias?

One way to minimise the impact of hindsight bias is by keeping a trading diary. A trading diary is used to record your progress, keep track of your trading, and plan and refine your strategies. You should also use it to make a note of how you feel before, during and after each trade. By writing down whether you feel confident, afraid, hopeful or uncertain, you will be better placed to get a sense of when you were successful.

By mapping the reasons behind trading decisions and comparing them to the desired outcomes, you can use your past trades to inform your future strategy. So, instead of trying to make sense of what happened by oversimplifying the reasons for past events, you can learn from the outcome.

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What is anchoring bias in trading?

Anchoring bias is the tendency for traders to allow an initial piece of information to have a disproportionate influence on future decisions, regardless of its relevance.₁

For example, research by Kaustia, Alho and Puttonen showed that individual's estimates of stock returns were significantly influenced by the starting value they were given – the 'anchor'₂. When participants were given a high historical stock return they were more likely to estimate that the future return would also be high, while a group given a lower initial value had far lower estimates.

Anchoring bias can have dangerous consequences in trading, as it might mean that a trader holds on to an asset far longer than they should do, or that they make an inaccurate assessment of an asset's worth based on the anchor value.

How can traders prevent anchoring bias?

The best way to prevent anchoring bias in trading is by performing comprehensive research and analysis of the market to identify your own anchor.

IG's study showed that only 28% of traders and investors used personal experience as a source of information. But by doing your own analysis of macroeconomic trends and historical data, you will be better placed to identify key support and resistance levels. It is important to have confidence in your own plan before you look at someone else's estimates – whether this is an analyst or fellow trader.

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How does 'availability bias' affect traders?

Availability bias is the tendency to open or close positions based on information that is easily available, rather than sources that are more difficult to find. It can cause traders to act on false or unverified information, which can lead to higher levels of risk and loss.

Traders tend to lean towards what is personally most relevant, recent or emotional, even long after the event is over. The mind can take a shortcut based on examples that come to mind immediately, rather than on research and analysis. For example, if a person has a family member who recently lost money on a bitcoin trade, they may be less inclined to speculate on the cryptocurrency because it is hard for them to imagine that the market can be profitable.

In fact, a study by Moradia, Meshkib and Mostafaei found that there is a strong correlation between judgement and data availability. By surveying investors of stocks listed on the Tehran Stock Exchange, the researchers concluded that decision-making would likely improve as the amount of information released to the public increased.₁

How can traders prevent availability bias?

The most common way to prevent availability bias is to conduct extensive research and analysis. Participants of IG's survey were comfortable using multiple sources to gather information on trading and investing. Although 56% used the internet, some also used newspapers, specialist publications, financial advisers, television and podcasts.

Fundamental analysis is used to examine internal and external factors such as earnings reports, how the sector is performing, and the health of the economy, while technical analysis looks at historic price data and indicators to establish key entry and exit levels for each trade.

If you don't feel confident enough to trade on live markets, you could test your strategy on a demo account first. This enables you to practise trading with indicators and test your strategy in a risk-free environment using virtual funds.

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What does 'boredom' mean in trading?

Boredom in trading is the tendency for traders to get fed-up with the financial markets and feel that their routines have become monotonous. This can cause a trader to deviate from their plan and take unnecessary risks to try and stir up some excitement.

Boredom might arise if the markets are moving slowly, or if a trader hasn't profited as much as they thought they would. As a result, a trader might start sensation seeking to combat boredom – searching for varied, novel, complex, and intense sensations and experiences.₁

However, this can lead to excessive risk taking. Wong and Carducci carried out research in which they devised a 'sensation seeking scale' (SSS) to show how susceptible participants were to sensation seeking and unnecessary risk taking due to boredom. On the SSS, male participants were more susceptible to sensation seeking and boredom than their female counterparts.₂

How can traders prevent boredom?

The effects of boredom can be prevented by using a demo account to create and test new strategies in a risk-free environment. This could be beneficial if you are fed up with your current trading methods and want to try something new.

Demo accounts enable you to trade without risking your own money. Traders can still get thrills from trading on a demo account, and it can even help them to strengthen their own abilities to pursue greater profits on the live markets.

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What does 'frustration' mean in trading?

Frustration in trading is the annoyance traders feel when the markets have behaved in a way that they didn't anticipate. The largest cause of frustration is loss, but it could also be that a trader didn't gain as much profit as they thought they would.

The time of day at which a trader incurs a loss, or a series of losses, can have a big impact on how frustrated they feel. Research by Coval and Shumway shows that traders who experience morning losses are about 16% more likely to assume above-average afternoon risk than traders with morning gains.₁

Adding to this, IG's survey found that inexperienced participants were more highly impacted by negative emotions than experienced traders – meaning that they might be more affected by the frustration caused by losses.

How can traders prevent frustration?

Frustration can be prevented by understanding that you will almost certainly incur losses during your time on the markets. The important thing to remember is that losses can be managed by attaching stops and limits to your trades.

Stops will restrict your losses, while limits will lock in your profits at a level which you see as favourable. As a result, stops and limits can help to take the decision about whether to close a trade out of your hands – so you could be less inclined to let your losses run out of frustration, or in the hope of eventual profits.

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What does 'hope' mean in trading?

Hope in trading is a feeling of expectation and is often linked to optimism, confidence or experience. While all traders need to have some hope when they open positions, there can be downsides of excessive optimism. For example, a trader might hold on to a losing trade because they believe that it will reverse its trend and become profitable.

A study by Nofsinger revealed that traders find it difficult to cut losses because they view it as an admission of defeat. Traders hope that the asset will recover so they won't have to face the realisation that it may have been a bad decision to open the position₁.

Hope can also determine how frequently an individual trades and how much they risk. For example, Germain, Rousseau and Van state that 'optimistic traders purchase more or sell smaller quantities, whereas pessimistic traders sell more or purchase smaller quantities than if they were realistic.'₂

How can traders prevent hope from impacting their decisions?

One way you can prevent hope from impacting your decisions is to set out a number of goals – possibly in a trading log or diary – for your time on the markets. By setting goals, you know exactly what you should be hoping for from your trading, which means that you could be less inclined to let losses run out of frustration.

Equally, a set of goals can help to manage expectations, so you could be more inclined to be happy with what you have earned. This could prevent greed getting the better of you and stop you from opening new trades in the hope of earning more.

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What does 'greed' mean in trading?

Greed in trading is the impulse to act in irrational ways in pursuit of excessive gain. It manifests itself when a trader gets overenthusiastic and trades beyond their means – opening more positions than usual or holding on to positions for too long because they are chasing an even greater gain. In doing so, they might incur a heavy loss and may even wipe out the profit they have already made.

Greed has a lot to do with how often an individual trades, or equally, if a trader thinks that they should be trading more. A study by Graham, Harvey and Huang found that, when measuring a trader's confidence levels, a small gain in their confidence levels resulted in a similar increase in their trading frequency₁. This tallies with IG's survey, which found that an average of 42% of respondents felt that they should invest or trade more with a lack of knowledge or confidence likely to be holding them back.

However, while traders might feel confident enough in their abilities to trade more, research by Park, Bin Gu, Kumar and Raghunathan has found that those who trade more often might actually achieve lower realised returns.₂

How can traders prevent greed?

You can prevent greed from affecting your positions by becoming familiar with risk management strategies. Risk management strategies can help you to understand the risks associated with trading with leverage and why you shouldn't overexpose yourself to the markets.

One of the most effective ways to manage risk is to use a risk-to-reward ratio, which compares the potential loss to the potential gain for each trade you open.

An example of a risk-to-reward ratio would be if you placed a £300 trade that had the potential to realise a £600 profit. In this scenario, the risk-to-reward ratio would be 1:2 as you stand to gain twice as much as you stand to lose should your predictions be correct.

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What does 'fear' mean in trading?

Fear in trading is the distress caused by the threat of loss, real or imagined. Fear can help to keep impulsivity in check but it can also cloud decision making, causing a trader to close out a position too early, or miss out on a profit by being too afraid to open a trade.

Research by Lee and Andrade has found that when fear was induced in a group of traders – by showing them clips from horror movies – only 55% of participants wanted to hold on to their positions. This contrasted with a control group in which fear was not induced, where 75% of the traders still held onto their positions.₁

IG's own study showed that less experienced traders were more affected by fear and uncertainty when compared to professional traders. One explanation for this is that professional traders might have experienced more losses than traders who are just starting out, and so could be more comfortable with the risk of loss to secure a profit.

Equally, more experienced traders might have more discipline, meaning they recognise the benefits of closing a losing trade, rather than letting it run.

How can traders limit the effects of fear?

One way to limit the effects of fear is by approaching every trade with a plan, and by placing stops to reduce any losses and limits to lock in profits. If you have carried out sufficient technical and fundamental analysis before you open a position, and if your stop or limit is placed at the correct level, you should be confident in the fact that you have done everything in your power to prevent unnecessary losses.

Technical analysis is a great way for you to identify the best levels at which to place a stop or a limit. One form of technical analysis which enables you to do this is a Fibonacci retracement, which you can use to highlight levels of support and resistance.

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How can 'competition' affect traders?

Competition is the pressure to make more money or place more trades than others. While trading is considered a competitive practice, traders should have the patience and discipline to follow their own trading rules and plan.

Competition can cause a trader to adopt bad habits – for example, a 'win at all costs' mentality, which could open them up to negative emotions and impulsive trading decisions. A study by Dijk has found that traders put up 50% more in a risky situation when peers would be aware of their decisions than when they were in an isolated individual setting.₁

Not only should traders be wary of competing against each other, they also shouldn't compete with themselves. By trying to beat a record or increase a profit every day, traders might be forcing themselves into trades that they wouldn't normally make.

How can traders avoid competition?

To avoid competition, you can create a routine that is based on your trading plan and risk management strategy. One popular tool is a trading diary, which helps you keep record of your trades – including why you entered them, the expected profit, how you chose to minimise your market risk, your entry and exit points, and how the market behaved.

You should focus on yourself, as there is more potential in self-development and learning than in competing with others.

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How can the 'news' affect traders?

The news can put pressure on traders to make certain decisions and interpret information in a particular way. News is a crucial part of information gathering, but it's important for traders to interpret the news objectively.

Forythe, Nelson, Neumann and Wright studied 192 traders' opinions on US elections and found that the individuals who dispassionately interpreted the news, and resisted confirmation bias, were more likely to make a profit₁. In contrast, those who traded the news and exhibited availability bias became overconfident and this increased their risk.

How can traders use financial news?

Using financial news is a great way to stay abreast of changes in the market and to help you fine-tune your strategy, but it is important not to become over-reliant on one source as this can create a narrow view of the market.

Fundamental analysis is a common way of gathering information. It is the use of various internal and external factors – like news, macroeconomic data and company announcements – to decide how much a particular asset is worth.

However, it is also important to use technical analysis too. This can help you predict the future direction of a market's price, by studying historical chart patterns and formations. It involves applying technical indicators, such as Fibonacci retracements and moving averages, to identify price patterns and key levels.

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How do 'rumours' affect traders?

Rumours in trading are any type of unverified claim that can influence traders' decisions. Rumours can cause traders to make mistakes by influencing them to enter and exit positions based on fear and greed rather than fact.

Rumours can be favourable or unfavourable towards a financial asset, which can cause traders to either buy the asset or sell it prematurely. For example, in 2002 there was a rumour that United Airlines was entering bankruptcy, which caused the company to lose 73% of its market capitalisation. However, this rumour was false. A study by Marshall found that although participants were aware of the false information, they held their positions for twice as long as expected.₁

According to IG's survey, websites and news reports are traders' most popular sources of information – potentially making them susceptible to rumours.

How can traders avoid rumours?

It's impossible to avoid rumours or fake news completely – they're everywhere, but traders can control how they react to them. Markets can become extremely volatile when a rumour is spread so it is important that traders remain as rational as possible, and always consider the risks when trading.

Rumours that are widely reported can have their place in fundamental analysis, but you should always assess the source and reliability of the rumour carefully, before factoring it in. This should never be done without a risk management strategy in place. With a risk management plan, you can set stops and limits to prevent larger-than-expected losses, as well as trading alerts that give you a choice of whether to act or not.

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What does 'herding' mean in trading?

Herding in trading is the tendency for traders to follow others without doing their own research and analysis. They will observe that there is a trend among other traders, and then feel the pressure to jump on the bandwagon, even when there is no clear reason for them to do so.

A herd is often driven by fear and greed, as traders don't want to miss out on opportunities that others are taking. However, basing decisions on herds can lead to information processing errors and inhibits learning.

Research by Kremer and Nautz stated that herding can lead to bubbles and crashes if trades are not based on analysis₁. An example of herding can be seen in the 1990s to 2000s dotcom bubble. Traders were all buying into the market, because 'everyone was doing it', but then the bubble burst and many people suffered severe financial consequences.₂

How can traders prevent herding?

The first step to preventing herding is to make decisions based on your own trading plan and research.

Although social trading is becoming increasingly popular, it's important to be mindful of your personal plan, and not just do what others are doing for the sake of it. This is why many traders set SMART goals to keep themselves focused; these are goals that are specific, measurable, attainable, relevant and time-bound.

Remember, financial markets can be unpredictable – so it is important to stay aware and do your own research.

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