Confirmation bias has ended thousands of traders’ careers. Out of all of the day trading tips I have mentioned in the past, I believe this is one of the most important. If you do not understand this concept and how it affects your trading, you will open yourself up to the possibility of huge trading losses that could end your career. Here is how you can identify and prevent this deadly psychological bias from destroying your trading account.
Confirmation Bias Definition
Confirmation bias is psychological phenomenon we see a ton in traders, especially in stubborn ones. It is defined as “the tendency to interpret new evidence as confirmation of one’s existing beliefs or theories.” One of the most common ways we see confirmation bias destroy traders is with their use of indicators.
Indicators and Confirmation Bias
Trading indicators is one of the most common ways traders bring the negative effects of confirmation bias into their trading. Often traders, especially new ones, will use so many indicators that eventually they find one or two that supports their trade thesis.
These indicators make traders overconfident in their thesis and make them stay in losing trades way longer than they should. In these cases, the stop loss for the trader will usually be how much pain they can tolerate. Traders who cannot combat confirmation bias will end up taking massive trading losses.
Look at the daily chart of HEAR, a recent big runner that went from $7 a share to over $20 a share in about 4 trading days:
An RSI over 70 is known to signify when a stock is in overbought conditions. During its run-up from April 16th until today it has stayed above 70, with the exception of a couple days recently. Despite the high RSI, HEAR has continued to uptrend and has only had a couple small pullbacks. If you were short this just because its RSI was over 70 you would have gotten smoked.
Many shorts used its high RSI to confirm their belief that this was overbought, which meant it was going to crash in the near term. The company might have poor fundamentals, but you cannot ignore the fact it is in an obvious uptrend.
There is a very obvious series of higher highs and higher lows since mid-April. You cannot just pull out indicators to confirm your thesis about a stock. You must always respect price action, which trumps every other indicator out there.
Define Your Risk and Reward
In order to avoid falling victim to confirmation bias in your trading, you need to define your exit strategy BEFORE entering a trade. Defining how much you risk before a trade allows you to know what your max pain is. It mentally prepares you for the loss and will eliminate a ton of the need for confirmation bias.
You must accept the possibility of a loss before each trade. No trading strategy has 100% win rate. If you have difficulty cutting your losses when you’re supposed to, use hard stops to take you out of your position. Automate as much of your trading as possible to minimize the effects of psychological biases in your trading.