- What are Cognitive Biases?
- Understanding Cognitive Biases in Algo Trading
- Types of Cognitive Biases in Algo Trading
- Techniques for Managing Cognitive Biases
- Being aware of biases and consciously avoiding them
- Getting feedback from others to challenge biases
- Incorporating rules-based trading strategies
- Final Thoughts and Recommendations
- Overcome Your Biases and Trade With Tradetron
Trading psychology plays a giant role in determining algo trading outcomes.
You’d think nothing could be more cold and calculating than having algorithms execute buy and sell decisions. Yet, every algorithm has human origins and is influenced, at least in part, by the prejudices and preferences of its creators.
That’s not to say the human component in algo trading is all bad. It is only certain irrational aspects of our decision-making that can potentially upend the effectiveness of an otherwise perfect algo-trading strategy.
That’s why it’s not unusual for even the most experienced algo traders to occasionally misread market trends, act on emotions, and incur losses. Read on to find out how a better understanding of cognitive biases can help you avoid such eventualities.
What are Cognitive Biases?
A cognitive bias is a glitch in human thought processing. These biases come into play whenever we allow our judgement and responses to be guided by subjective feelings, beliefs, or experiences. Think of them as an automatic filter engaged by the brain to oversimplify information in line with our assumptions and preferences.
Here are a few everyday examples of cognitive bias that many of us may be subject to:
Assuming someone’s gender based on their profession. For instance, to think of all nurses as being female and all fighter pilots as being male.
Attributing qualities based on age. For instance, thinking all senior citizens are out of touch, or children cannot be trusted with tools.
Stereotyping based on outward appearance. For instance, considering the most smartly dressed real estate agent to be the most trustworthy.
Cognitive biases can be innocuous and seem perfectly rational until they are put to the test. They are benign in most cases and often ignored because we see many others thinking or acting the same way. That’s not the case, however, in an algo trading environment, where cognitive biases can lead to major negative impacts.
Understanding Cognitive Biases in Algo Trading
Investing is a decision-intensive practice. Because we can be guided to a large extent by our personal beliefs and value systems, there’s a fair chance of having cognitive biases influence our algo trading decisions as well.
It wouldn’t be wrong to say trading in general, and algo trading in particular, are uniquely susceptible to cognitive biases. Traders are driven by their own set of expectations, beliefs, fears, and other psychological traits. That can lead them to manipulate expectations, make flawed interpretations of trends, and force negative outcomes.
It’s crucial, therefore, to make a conscious distinction between being insight-driven and being cognitively biased.
Types of Cognitive Biases in Algo Trading
Cognitive bias is an umbrella term used to cover a wide range of psychological phenomena. Let’s understand the most prominent types of cognitive bias so you can be aware of them and exclude them from your trading decisions.
It refers to seeking out information that confirms pre-existing beliefs and ignoring information that points to the contrary. Confirmation biases are self-reinforcing because they tend to strengthen themselves with each instance. To use an example, a trader who prizes the shares of a particular company may ignore negative information about that company. Research shows that, given the choice, traders are more likely to read a news article that supports an investment decision they’ve made rather than one that opposes it.
This is a type of cognitive bias that seasoned traders are often more prone to. It is defined as the tendency to overestimate one’s skills, knowledge, and intellect in general terms or regarding a particular field. For instance, an experienced trader who is fully aware of market conditions, stock trends, and margins can still make catastrophic decisions. It usually happens when potential risks are sidelined because of overconfidence in one’s trading abilities.
Hindsight bias is the false assumption we make of having predicted an occurrence or outcome the moment we learn of it. It’s more common than you can imagine. It’s evident every time someone exclaims “I knew it!” when they hear of their chosen candidate winning an election, for instance. One of the subsets of hindsight bias is what’s known as ‘Monday morning quarterbacking’: the tendency to presume not only foreseeing the outcome of a game but also how that outcome could have been changed. As you can see, hindsight bias is particularly relevant in the volatile and unpredictable world of algo trading.
People with availability bias tend to favor the most readily available information when evaluating a situation or making a decision. It can manifest in various ways. For instance, when deciding between two brands of soap at the supermarket, we’re more likely to pick the one we recently saw an ad for. Availability bias is best described as the tendency to make decisions based on easily-recalled past experiences.
Remember believing as a child that whoever went to their parents first with a complaint about their sibling tends to be believed. You were right! It’s human tendency to believe anyone who pleads his case first. That’s because anchoring bias causes us to rely overly on the first piece of information we come across in any given situation. That first bit of information becomes an anchor around which we arrange all subsequent information.
Techniques for Managing Cognitive Biases
Despite their constant presence, managing cognitive biases is not as difficult as it may sound. The best way to deal with them is to limit fast thinking - which relies on mental shortcuts, in favor of slow thinking - which gives you time to reason and evaluate.
Here are a few effective practices to help you override cognitive biases in trading environments:
Being aware of biases and consciously avoiding them
Being self-aware is one of the easiest ways to eliminate cognitive biases. Knowing your innate tendencies and predispositions is the first step toward overcoming them. Evaluate your trading decisions objectively and identify if your biases have come into play at any stage of the decision-making process. Doing this regularly will limit your susceptibility to cognitive biases.
Getting feedback from others to challenge biases
Biases usually negate themselves when decisions are taken in coordination and consultation with others. Taking a colleague’s advice on whether to take a short position on a specific stock, for instance, can help you identify and rectify any biases that may have influenced your decision. Another way of doing this is by sharing the path you took to reach a particular conclusion with a colleague and inviting their observations on your process.
Incorporating rules-based trading strategies
Rules don’t make fools! That is especially true when you’re dealing with cognitive biases in algorithmic trading.
Rules help you stay within boundaries and can help streamline your thinking process. Be cautious of acting hurriedly upon ideas that don't follow the rules outlining your trading strategy. Some amount of flexibility with trading rules can be worthwhile at times, but only as long as they are made with a clear and unbiased mind.
Final Thoughts and Recommendations
Investing is all about making the right decisions based on all available information. Better-planned, better-timed, and better-executed decisions yield better profits. Getting rid of cognitive biases is crucial for any algo trader to sustain and succeed. Make sure to follow the techniques discussed above to make your trading decision free of cognitive and emotional biases.
Overcome Your Biases and Trade With Tradetron
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