Behavioraleconomics and its principally related twin, behavioral finance, seeks to combine psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. This year, behavioral economist Richard Thaler won the Nobel Prize. His work in describing how we think about money is monumental and has large implications for currency traders who are looking for a psychological edge to beat the market. Thaler isn’t the first person to earn the highly coveted award for contributions toward the trendy sub-field of behavior economics. Daniel Kahneman an Israeli-American psychologist won the award in 2002 for his paradigm-shifting work onhuman judgment and decision-making under uncertainty. Along with Amos Tversky, Kahnemanoutlinedsome of these psychological processes in developing prospect theory - a description of how people choose between different options (or prospects) and how they estimate, many times in a biased or incorrect way, the perceived likelihood of each of these options.
Prospect theory should be considered mandatory reading for any serious currency trader with special attention given to understanding ‘loss aversion;’ a description of the concept where people prefer avoiding losses to acquiring equivalent gains: it's better to not lose $5 than to gain $5.When traders close winning trades early,but then patiently wait as long as necessary to avoid closing losing trades, this is known as the disposition effect and it is a form of loss aversion. From novice to experienced traders,the disposition effect is probably the most ruinous anomaly and to avoid this effect from negatively affecting performance, behavioral economists recommend periodically selling underperforming assets or placing stringent time limits forallowing positionsto remain open.
Within prospect theory, another described effect applicable to currency traders is a diminished sensitivity to gains and losses. The effect can be measured through a ‘value function’ given to gains and losses accrued from starting reference point (please see diagram below). Diminishing sensitivity means that people's sensitivity to further changes in gains/losses is smaller for accrued profit/loss positions that are further away from the reference point. For example, if a currency trader over the course of a year accrues $50,000 profit from a starting balance of $10,000, the next $1000 profitable trade will not be ‘felt’ to be worth as much as the profitable $1000 earned at the beginning. In addition to overconfidence, this effect may explain why successful traders get sloppy over time and deviate from refined and lucrative strategies. Periodically renewing a commitment to a strategy and adjusting it as necessary is a way to mitigate the bias of diminished sensitivity for gains/losses.
Basic knowledge of behavioral economics can contribute to your success as a trader in numerous ways. As noted above, Kahneman and Tversky’s prospect theory can contribute to better trading psychology and applicableconceptsthat can be tacked on to existing strategies relatively easily. In part 2, I will describe how some of Thaler’s award-winning findings can benefit even the most rookie of traders.
All essays, research and information found above represent the analysis and opinion of Leverate only. As such it may prove wrong and be a subject to change without notice. Opinions and analysis were based on data available to the author of the respective essays at the time of writing. Although the information provided above is based on careful research and sources that are believed to be accurate, Leverate does not guarantee the accuracy or thoroughness of the data or information reported. The opinions published above are neither an offer nor a recommendation to purchase or sell any securities. Leverate is not a Registered Securities Advisor. By reading Leverate’s reports you fully agree that they will not be held responsible or liable for any decisions you make regarding any information provided in these reports. Investment trading and speculation in any financial markets may involve risk of loss.e risk of loss.
Editors’ Picks
EUR/USD eases below 1.0850 on renewed USD strength
EUR/USD stays under pressure and trades in the red below 1.0850 in the European session. Although the ZEW survey for Germany and the Eurozone showed a noticeable improvement in economic sentiment, broad USD strength doesn't allow the pair to gain traction.
GBP/USD drops below 1.2700 on notable US Dollar demand
GBP/USD is extending the downside below 1.2700 in the European trading hours on Tuesday. The ongoing bullish momentum in the US Dollar, despite sluggish US Treasury bond yields, undermines the pair. Mid-tier US housing data are coming up next.
Gold price struggles to lure buyers, holds steady above one-week low ahead of FOMC meeting
Gold price ticks lower amid reduced Fed rate cut bets, elevated US bond yields and stronger USD. Geopolitical tensions could lend some support to the safe-haven XAU/USD and help limit losses.
Why is the crypto market crashing?
The two most important contribution to the ongoing bull market is the meteoric rise in Bitcoin due to the ETF approval and the sudden interest spike in Solana ecosystem. But the recent move suggests that the upward momentum is dissipating and a correction looms.
Canada CPI Preview: Inflation pickup could scale back bets on early interest-rate cut
The Canadian Consumer Price Index is expected to have risen by 3.1% YoY in February. The BoC shows no rush to lower its interest rate. The Canadian Dollar maintains its multi-day lows against the US Dollar around 1.3540.
RECOMMENDED LESSONS
Making money in forex is easy if you know how the bankers trade!
Discover how to make money in forex is easy if you know how the bankers trade!
5 Forex News Events You Need To Know
In the fast moving world of currency markets, it is extremely important for new traders to know the list of important forex news...
Top 10 Chart Patterns Every Trader Should Know
Chart patterns are one of the most effective trading tools for a trader. They are pure price-action, and form on the basis of underlying buying and...
7 Ways to Avoid Forex Scams
The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?
What Are the 10 Fatal Mistakes Traders Make
Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.