Year 2017 is closing and I am in mood for some light-hearted banter yet to write meaningful article. So here I go talking about some behavioral economics and its implication on forex trader and his trading. Behavioral economics in essence is a method of analysis that applies psychological aspect of human behavior on economic decision-making.

Although the terms mentioned in this article have wide implications in different economic decision making process, I will keep the scope of these terms to forex trading and investing only.

  • Framing

Fig. 1

Framing refers to how a trader perceives a forex movement of a pair. It’s a glass half full or glass half empty kind of situation(same as above comic strip). In last 2 weeks gbp/nzd is correcting from 1.98 to 1.90 zone. So when price retrace to 1.93, a trader may think, wow the pair is at 3% discount and will try to buy only to find price go even lower. So it is important to see that pair is in strong corrective mode after more than 10% rise in last 2 months.

The key is to perceive the market correctly and never feel that “I am most intelligent”. Follow technical’s and wait for the pair to form a support/resistance in strong correction / retracement . And avoid this behavioral trap.

  • Overconfidence

Fig. 2

Everyone has different set of abilities and skill sets
. And if one organization does well on one specialized job it does not mean they can do all kind of work in the world as depicted humorously in above comic strip.
Same way if in one profession a trader is superstar, it does not mean he is successful trader too unless until proven by years of consistent performance. Confidence is essential but overconfidence kills the results. One week of good results say 10 percent return does not mean anything if the same cannot be sustained for a year. But often traders get overconfident of their abilities (me included) and ruin chances of their success.

Winner’s curse phenomena is the perfect example of why bubbles happen which takes prices of an asset beyond its intrinsic value. It’s important to take rational decision, avoiding inflated ego and be sane while taking trading decisions objectively.

  • Confirmation bias

Fig 3

It is personal bias and trader seeks to find evidence to support their prior belief as depicted in the above comic strip on manger's prior belief confirmation . Say a trader believes that GBP/USD will bounce after good fall over 2-3 days. What happen next when trader find 10 pip gain only to find it going down in 20 pips loss after an hour.
Only way to not fall into this trap, a trader should do good technical study on all time frames and avoid personal biased opinion.Find good reasons why the pair should be bullish or bearish and not overlook the price action. A trader should do what market is doing and not what he thinks is right. Avoiding ego on being right can help in dealing with confirmation bias.

  • Loss Aversion bias

Fig 4

In prospect theory pain associated with loss is much greater than pleasure associated with gain of same magnitude. In trading avoiding losses can be serious dent on the health of traders account. We have to accept that losses are necessary and cannot and should not be avoided.
Even dilbert’s garbage man understands this fact and a trader should definitely embrace the pain with small losses for bigger gains.

  • An expert advice

Fig 5

As a trader you have to decide, what you have to do. You either looking inside yourself to work on your behavioral economics issues or asking others for advice as above comic strip. Decision is totally up to you.

Wish you all a very happy X-Mas and New Year.
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