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Lets begin with the definition of heuristics:

Heu·ris·tic: Is any approach to problem solving, learning, or discovery that employs a practical methodology not guaranteed to be optimal or perfect, but sufficient for the immediate goals.

As a Trader, you are a professional problem solver. Defining Market direction is your never ending problem, and unfortunately, if you are wrong you don’t usually make less profit; you lose entirely.

This blog is the first in a series of identifying heuristics that Traders (really everyone for that matter) depend on to make profitable decisions. Many Trader’s lifelong goals are to create trading systems aimed at cutting their emotional ties to the Market. Most of the time these systems fail, but that is an entirely different topic that we have covered in the past (The Trader’s Prison). For the rest of us learning to read what story the Market is telling, heuristics play a large role in our processes to define a trading opportunity. This is a well researched subject, and I would recommend anyone interested in learning all you can about it. Many of these topics can be found in Daniel Kahneman’s Thinking, Fast and Slow.

Confirmation Bias: Also called myside bias, is the tendency to search for, interpret, or recall information in a way that confirms one’s beliefs or hypotheses, in order to make quicker decisions based on relevant information.

This bias is all too common in trading. A good example of this bias taking place is when you first sit at your computer and think to yourself “look at that, the market is running short/long. I think this is a great time to go in the opposite direction. There’s no way it’ll keep going.” A brief scan solidifies your stance on Market direction and you enter a trade.

Only after you enter and begin full concentration on exactly what trade you just made does it dawn on you how terrible your analysis really was. This bias stems from allowing intuition to take the reigns on your mind, and leaving your initial notion unchecked, foregoing a thorough analysis.

To make this wrong into a right, I cannot stress the importance of an analysis “ritual”. Much like many of you drink your coffee in the morning, it helps you get into the correct mindset to kick things off. Asking yourself important questions pertaining to the movement such as, “why is price moving this direction?”,  “has a stop-out taken place?”, or “what does this say about retail beliefs?” This leads us to our next heuristic…

As a side note: FX365I strongly discourages its Traders from jumping on the charts and placing a trade immediately without any analysis, but everyone slips from time to time.
Substitution: This heuristic is meant to more efficiently answer complex questions by replacing the question, usually without our knowing, with an easier question. An example could be you asking yourself “what is the secret of happiness?”, when many people will often instead answer, “what is my current mood?”, without realizing they’ve done it, or the effects that could have on the answer. This heuristic is necessary, as it helps with intuitive thinking, but can be detrimental to a Trader when left unchecked.

An example of substitution in Trading is watching strong movement on the charts and thinking to yourself, “how could I take advantage of this setup?” When instead we ask ourselves, “how did I feel last time I missed the Trade of the day?” These two questions lead to very different answers, one logical, while the other is emotion driven and feels good because of how intuitively it was answered. As a Trader this heuristic is at full force if you have already taken a negative trade.

To work around the substitution effect a Trader has got engage hard mental work on answering the exact question they are asking themselves. Intuition feels good, and there are certainly moments it can be helpful, but letting it run free before you have a real plan is account suicide. Emotion in Trading is widely regarded as taboo, but is not inherently bad to have. The entire reason you started Trading is because of the emotions you experienced regarding the “Pro-Trader Dream”. Accepting that we all have these flaws in thinking (which are actually benefits in countless other contexts) and working at keeping a reign on them is much more realistic than completely eliminating them. Learning how our psyche works in a bizzaro world like the Forex is hard work, but obviously worth it. That’s it for now! Be on the lookout for next weeks piece on Heuristics in Trading. And be sure to subscribe to keep up to date.

-Shane Guth

Director of Smart Money Course