Sunday, January 03, 2010

Turning Availability Bias Into Trading Opportunity

The recent post on decision making in trading explained how our field of vision tends to narrow and our cognitive processes gravitate toward simplicity when we operate under conditions of psychological stress. Readers will recognize this as the availability bias described by behavioral finance researchers: decision-makers tend to gravitate toward the most available information--what is most salient at the time--when pressured to make a choice.

This is why traders seem to buy near highs and sell near lows with dismaying frequency. What is most salient at the time is that the market has been rising or falling. Afraid to miss the move or unable to take further heat on a trade, traders react to the most recent price action and act at the worst possible times.

How can we escape the narrowing of perception and biasing of decision-making under conditions of stress? One technique that I have found to be very helpful is a conscious routine that I go through whenever I am feeling pressured by the most recent market action. The routine has several steps:

1) Take a deep breath and get settled and focus;

2) Make a mental reminder that the situation requires my attention but is not an emergency. If I've sized my position properly and haven't touched a stop-loss level, adverse market action should *never* be an emergency;

3) Remind myself that other people in the market may be feeling similarly and may become reactive to the situation, making the current stressful situation a potential *opportunity*;

4) Purposefully broaden my field of vision to see what is happening in related sectors, asset classes, and indexes and what is happening in relevant market indicators, such as volume, TICK, etc.

5) Let the decision come to me based upon the broad survey and evolving market action, rather than impose a decision out of impulse.

The key is that I turn from the market to myself to steady myself and focus my attention before cognitively reversing the narrowing of perception. Seeing the whole field is much easier if I'm in the right state of mind and body. Often, just a few seconds devoted to self-management and a broadened perspective can allow traders to avoid impulsive decisions and turn seeming crisis into opportunity.

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