As you may already know, trading can create a wide range of emotions, including fear and excitement. Often, traders swing from fear to excitement, back and forth.
Most attention is given to phases of fear, but, at times, traders can also become too confident of their analysis which may lead to confirmation bias.
One of the most difficult aspects of trading is to find a balanced mindset. This article provides our best tips how to find the best approach.
The Roots of Confirmation Bias
Confirmation bias occurs most often when traders are very sure of their analysis or trade setup. One very common example is when traders think that a trade setup is (almost) a "sure" win. Why?
Because traders tend to think that all positive price action confirms their view and bias... whereas any price movements going against their trades is just "temporary". Basically, their mind is in a denial phase, when the market is not confirming their analysis.
Confirmation bias is the strongest when traders have a strong feeling or sentiment about their analysis, setup, or trade management. They become convinced that:
- The market will for sure follow their analysis.
- The market has no other choice but to confirm their analysis or setup.
- The market is wrong or stupid if it doesn't follow their analysis or setup.
- Any signals that indicate the opposite are false flags.
The consequence of being overconfident is that traders lose their balanced mindset and their view becomes strongly influenced by their beliefs. They lose the ability to analyse and judge the charts on their own merit. Their current trade stands in the way of truly analysing price action, price patterns, and anything else on the charts.
Which traders suffer the most from this type of bias? It happens when traders have a winning streak, but it is certainly not the only scenario. It also depends on the type of trader you are:
- Analytical types of traders have less problems with confirmation bias as they tend to even overthink their analysis. They keep checking both sides of the trade and often have more problems with insecurity during a setup than overconfidence.
- Strong opinionated types of traders will run into the confirmation bias more often as they analyse less on the average and are more prone to seeing their setups as 'correct' and the market as 'wrong'.
Confirmation Bias: Where and When?
Confirmation bias can really occur at any moment. An obvious moment is when a trader has just entered a new setup. Let's review the most common situations so that traders can be on guard and defend themselves better against confirmation bias.
#1: Just After Entering a Trade Setup
Your analysis has just been completed, and the trade makes sense. You become convinced that the setup must work out. Unfortunately, there is no such thing as a certain win... The market can move up or down as it wishes, regardless of how good your setup may look like. It is best not to see any trade as a certainty but rather be open to new developments and possibilities.
#2: When a Trade is Going Our Way
This is an easy trap to fall into. The trade setup seems to be going our way so all seems safe until the price suddenly turns against your position. The price action signal is often ignored because traders received an early boost of confidence when the setup was working well at the start, but nothing is guaranteed.
#3: When a Trade is Going Against Us
Some traders become actually more attached to their trade setup when the price is actually retracing against their position. Once again, the development of the setup should not automatically be ignored. It could be wise to see whether there are any patterns that look alarming and could merit an exit to cut the loss short.
#4: During Our Analysis
Sometimes, it happens that traders are overconfident when analysing the chart, but once they enter a trade, they lose trust in their analysis and give up on it. Overconfidence leads to entry, but fear kicks in once the setup is open and running.
#5: During a Winning Streak
A winning streak seems like a luxury problem because having a winning streak is a great development. That said, traders want to keep their two feet on the ground and avoid being too confident about each setup.
#6: After a Long Losing Streak
Although being overconfident does not seem likely after a losing streak, it could occur as a way to provide compensation to a string of losses. Sometimes, traders give extra confidence to one particular setup as a "last attempt" to win back their losses in a "now or never" fashion. Needless to say that such approaches are a wild gamble that often lead to emotional reactions. This is not a consistent method that traders want to implement.
How to Combat Confirmation Bias
Combatting confirmation bias is not as simple as hitting an on and off button, unfortunately. But with a few conscious and focussed steps, traders can go a long way in improving this bias.
The first tip is not seeing the market as a place where the trader is right and the market is wrong. The prices will move as they want, and our opinion, bias, or view will not impact it. Simply said, our thoughts or emotions will never make the price move up or down.
The price will move as it wants to. In my eyes and vision, it will move in accordance with the path of least resistance. My task as a trader is to analyse the path of least resistance and find trades within that path that make the most sense. I am more than ever aware that the path of least of resistance can change, depending on new information and price action that appears on the charts each minute, hour, and day (watch the video above for more information).
My second tip is to ask for advice a trading friend who knows you as a trader and knows your style of trading, otherwise, advice could work counterproductively. A trading buddy can help you see things from a 'neutral' perspective and try to remove/neutralise the emotions that you might feel with a setup.
The trading buddy doesn't have to be your real friend. It can be online as well, someone from a forum, Twitter, Skype, online live webinars, etc. Also, you do not necessarily need a trading buddy for this. You can try to ask yourself for advice by imagining and pretending that you are not involved in the trade yourself.
My third and final tip is to monitor price action and let candlesticks make decisions for me. Price action is a much better indication of direction, reversals, bounces, breakout, and trend continuation than anything else. Being able to read and interpret candles, momentum, correction, and price patterns allows traders to become better analysts and find a balanced level of confidence.
Wishing you a happy week of trading!