Forex Strategies #7 – Positive And Negative Prospect

Trading is a lot like going into battle

Sun Tzu – Art of war

知彼知己，百戰不殆；不知彼而知己，一勝一負；不知彼，不知己，每戰必殆

It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle.  – Wikiquotes

Almost every Forex trading strategy out there focuses on one side of the trade, whether it be the understanding of charts, markets, fundamentals, or, as Sun Tzu would put it, the understanding of your enemies, which would result in winning one and losing one.  If that’s what you’ve been experiencing in your Forex trading career, you need to pay close attention to the following.

Without getting into the details of understanding the human psyche and the reasons behind why we do the things we do or the choices we make, it is important to understand the simple fact that we are often influenced by how we look at things and the saying “glass half full / glass half empty” is without doubt, a simple yet amazing revelation of what this article is all about.  Let me explain:

The Prospect Theory

Consider the following problems posed by the study done in 1981 by Tversky and Kahneman (Prospect Theory):

Problem – the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs is as follows:

1. If Program A is adopted, 200 people will be saved.
2. If Program B is adopted, there is a 33.3% of probability that all 600 people will be saved but a 66.6% of probability that no people will be saved.

Which of the two programs would you favor?

If you are like 72% of people, you will choose Program A because you think of “risk averse,” as you would rather have a third of survivors than not at all.

However, here’s the same problem but with two different choices essentially offering the same solutions (remember, this test was done with two different groups of people, one group has access to only one problem):

Problem – Same as above, the U.S. is preparing to deal with disease outbreaks with 600 proposed fatalities.

1. If Program C is adopted, 400 people will die.
2. If Program D is adopted, there is a 1/3 probability that nobody will die and a 2/3 probability that 600 people will die.

If you choose Program D, you are like 78% of people thinking of “risk appetite,” as Program C and D are essentially identical to Program A and B, respectively.

In case you are wondering, there is a slight discrepancy between the 72% of people who chose Program A and the 78% of people who chose Program D, which almost implies that there are more risk-takers when the context is negative, as it is harder to make the decision and condemn 400 people to death than clinging to hope that perhaps ALL will be saved.

When we put into the trading terms, it seems clear why traders tend to close profits early (risk averse) while letting losing trades run (risk appetite); this is because the pain of losing outweighs the joy of gaining.

This framing effect, as described in Kahneman and Tversky’s (1979) Prospect theory, occurs because individuals over-weight losses when they are described as definitive, as opposed to situations where they are described as possible. This is done even though a rational economical evaluation of the two situations lead to identical expected value. People tend to fear losses more than they value gains. A $1 loss is more painful than the pleasure of a $1 gain. Describing a loss as certain, and therefore more painful, will inflict investors trying to avoid such a loss. As a consequence, they will take a greater risk and gamble in a losing situation, holding on to the position in hope that prices will recover. In a winning situation the circumstances are reversed. Investors will become risk averse and quickly take profits, not letting profits run.

Following the above understanding, here are insights to help you trade.  Remember, we are creatures of habits; the more you practice, the better you are.  The more you are exposed to this kind of critical thinking, the better you’ll be at making the right decisions:

Insight #1 – Evaluate the context of your trading decisions and be aware of the other side of the argument.

Is it to protect your profits (risk averse) when you close a trade? Or is it the right decision considering the full potential of the trade?

When you decide to stay in a trade, is it because you’re desperately trying to avoid the pain of taking losses?  Or is it the right decision as the market dictates?

Insight #2 – Do not over-leverage

You probably have heard this advice a thousand times from your fellow traders that over-leveraging is your biggest mistake.  Why? Because over-leveraging makes the pain of taking losses even more intense, cornering you into making the wrong decision every time.  What’s worse is when you should have taken a loss but stayed in the trade, not based on the market, but just because you didn’t want to face the pain, and the trade ended up positive as the market reversed…  This reinforces the wrong behavior by awarding you doing the wrong thing, eventually delaying your success.  Therefore, don’t over-leverage.

Insight #3 – Treat each trade as a new trade

Tversky and Kahneman further posed the following problems, and when applied to Forex trading, show the importance of treating each trade as a new trade because traders tend to become biased from recent trading experiences, thus likely to miss opportunities or make mistakes:

Problem – Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater, you discover you lost the ticket. The seat was not marked, and the ticket cannot be recovered.  Would you pay $10 for another ticket?

1. Yes
2. No

If you answer no, you are among the 54% of people who felt that the $20 is too much for the play. Now comes the twist:

Problem – Imagine that you have decided to see a play, and as you enter the theater, you discover that you lost a $10 bill. Would you still pay $10 for a ticket?

1. Yes
2. No

If your answer is Yes, you are among the staggering 88% of the majority who chose to pay for the ticket.  This demonstrates that our decision-making will be somewhat affected when we don’t see a new trade as new. 

To take a step further, let’s say you follow a proven strategy but have taken three losses in a row.  It will be increasingly hard to resist the urge to abandon the strategy, but if it is proven, you should stick to it.  The same thing also applies to trading the same pairs, and whatever happened on the previous trades should not impact the current trade.  It would help if you just focused on the strategy.

In conclusion, I believe by understanding your vulnerability, you’ll become a better trader, and at the risk of sounding like a broken record, we are creatures of habits. The more we do it, the easier it is.   Success is also a habit; nothing can stop you if you are in the habit of success.