Black Friday Sale - No Coupon Necessary!
By
David Dombrowsky

Anchoring Bias in Trading

Published on
January 17, 2024

In the financial markets, there is usually the tendency to rely on a single piece of information to make a trading or investment decision. In most cases, the buying and selling that takes place is anchored on a single piece of information, regardless of whether it needs to be updated or corrected. Such kind of behavior is often dubbed as anchoring bias.

What is Anchoring in Trading?

Anchoring bias is a behavior or tendency whereby traders place importance on the previous price or the first piece of information they receive to make decisions. As a result, the information is relied upon regardless of being correct or incorrect, often exposing traders to significant risks. In this case, the anchor information acts as the reference point from which future decisions are made.

Therefore, it prevents people from making informed or rational decisions whenever certain data points change, or new information exists. In the investment world, anchoring leads to traders chasing trades.


What is Anchoring Bias

Source: Pinterest


An anchoring basis also causes investors and traders to make bad decisions and chase first investments rather than looking for better alternatives. The cognitive biases also make adapting to the changing market environment challenging.


Anchoring Bias Examples

In trading, anchoring bias takes many forms.

Consider a trader who opens a buy contract on the S&P 500 Index at the start of a trading day on the market showing signs of edging higher. The trader holds the position based on the information used at the beginning of the trading day, regardless of what transpires in between. Even on the market showing signs of exhaustion and potential reversal, the trader refrains from selling the contract as their beliefs and decisions are anchored on the initial information about a bullish run and don’t wish to consider anything else.

Another trader buys Tesla stock based on price hikes and the belief that the company is poised to dominate the electric vehicle space for many years to come. Given that the trader is anchored on previous performance expectations and price hikes, they would be reluctant to sell even if the price starts to tank. Changing market trends and increasing competition in the EV space don’t sway the trader to exit the market as their trade is anchored on the previous information.


How does Anchoring Bias Affect Trading

Studies have shown that the human brain tends to anchor new information as it makes it easy to make decisions. Therefore, traders make trading or investing decisions based on the anchor information imprinted in their brains.

In most cases, anchoring bias in trading causes traders to use first impressions to make decisions or form further perceptions. Therefore, it might be found at any point in the trading decision-making process.


How anchoring bias affects traders

Source: CMT Association


Anchoring bias affects trading in various ways. First, it could lead to emotional attachment to prior prices or positions. In this case, one would make buy or sell decisions based on past prices.

Suppose a trader is strongly convinced that a given stock's price should be $200 based on previous information. In that case, they will make a buy decision after a significant sell-off, even if underlying metrics indicate the stock is overvalued.

Similarly, a trader may open a sell position on a stock if they strongly believe it should trade at $200 after a significant price increase. The trader would open a sell position even if current metrics and fundamentals indicate it is still undervalued, as the focus is on previous information rather than new data.


Why Anchoring Bias Happens in Trading

Despite the significant risks anchoring bias presents, it happens daily, affecting professional and novice investors and traders equally. The bias occurs due to the following:

Limited attention to decisions making

Whenever traders are under immense pressure and time constraints to make investment decisions, most base their decisions on previous data. Traders rely heavily on initial prices and data instead of conducting in-depth analyses and analyzing current fundamentals. The anchoring bias may result in the traders making incorrect decisions that hurt their portfolios.

Over-Reliance on Mental Shortcuts

Anchoring bias may also come into play in the absence of new information that traders can use to make informed decisions. Consequently, traders need to adjust their valuation based on new information, Such as changing market conditions. Instead, trades and investments are made based on the initial price that acts as the anchor or strong convictions.

Cognitive Biases

It’s the tendency to seek and rely on information to confirm existing beliefs. Ultimately, trades are made based on this information, which is extremely biased. Therefore, ignoring information that contradicts existing beliefs presents significant risks when it comes to making decisions.

Emotional Attachment

One of the biggest risks in trading is having an emotional attachment to a given stock or an underlying price. The attachment often leads to anchoring bias as decisions would be made based on previous experiences and prices rather than current information. For instance, a trader may be unwilling to close a position even on new information implying they should because they have an emotional attachment to the previous price. Consequently, traders should always watch out for fear, greed, and regret, as they can lead to anchoring bias.


How to avoid anchoring bias and make a profit in trading?

Anchoring bias presents significant risks when trading the financial markets. Any trading decisions should be based on current information and not anchored on previous data or prices. While it can be challenging to avoid anchoring bias, one can do a few things to avoid its pitfalls.


How to avoid anchoring bias

Source: Youtube.com


First, it is important to acknowledge anchoring bias by asking questions to ensure decisions are not emotionally driven or based on previous information or data. Always consider all available information and options while trying to buy or sell.

While making trading decisions, it is essential to consider all alternative scenarios rather than being fixated on a particular reference point. In addition, seeking and analyzing diverse sources of information rather than relying on one data point could also help avert the anchoring bias risk.

Additionally, traders must resort to rule-based trading rather than making impulsive or irrational decisions. Finally, diversifying an investment portfolio helps avoid becoming too attached to a given investment or position.


Ready to get funded?
Check out FX2 Funding's selection of the industry's simplest, most straightforward funded account programs.
Get Funded
Pass the prop firm evaluation
Want insider secrets that most prop firms don’t want you to know?
Learn More
Related Articles
June 4, 2024
Unraveling the Pros and Cons of Forex Trading

Everything you need to know before investing in FX Forex trading—the exchange of one currency for another—is a dynamic domain that beckons traders with the promise of financial gains and significant opportunities. However, just like any investment, forex trading has its own set of advantages and disadvantages. Whether you're contemplating a career in forex or […]

June 1, 2024
Trading Psychology Tips for Consistent Success

Master Self-Trust and Resilient Behavior Introduction Trading in the financial markets is not just about strategies and market analysis; it's equally about the psychological resilience and decision-making capabilities of the trader. Trading psychology plays a pivotal role in a trader’s ability to make consistent and rational decisions. Understanding and managing the psychological aspects of trading […]

May 29, 2024
The Most Traded Forex Pairs: Unveiling the Major Currency Pairs

In the vast and dynamic world of Forex trading, understanding the most traded currency pairs is essential for both novice and seasoned traders. These pairs are a cornerstone of the global currency market, offering the highest liquidity and the best opportunities for speculation and hedging. Traders gravitate towards these pairs because they represent economies with […]

May 27, 2024
Fundamentals of Risk Management: How to Best Protect Your Trading Capital

What Are the 5 Rules of Risk Management? Effective risk management is essential for successful trading, and adhering to core principles helps safeguard your investments. These rules are foundational in creating a disciplined trading strategy: What Is the 1% Rule in Trading? The 1% rule is a risk management strategy that suggests not risking more […]

May 21, 2024
Understanding Market Cycles: How to Recognize Trends and Reversals

In the financial world, understanding market cycles and their phases is crucial for investors aiming to optimize their strategies according to market dynamics. This guide will explore the nature of market cycles, their duration, stages, and how to identify and respond to various trends and reversals. What is the Cycle of the Market System? Market […]

May 12, 2024
What You Should Know About Currency Correlation

Read about positive and negative currency correlation. Check out the pairs trading strategy and the Forex correlation hedging strategy on the FX2 Blog.

April 29, 2024
Wyckoff Trading Method Explained: Step-by-Step Guide

Learn the four phases of Wyckoff theory. Wyckoff trading price movements. How to use Wyckoff’s method? Wyckoff trading strategy on the FX2 Blog.

April 25, 2024
Can You Day Trade For a Living With $1,000?

Day trading with $1000: how to start day trading with 1000 dollars, tips on how not to lose, and how much can you make. Strategy for small day traders on the FX2 Blog.

April 22, 2024
Getting Started with cTrader

Your Guide to the Market Profile Tool on the World’s Most Robust Trading Platform cTrader is a powerful trading platform known for its intuitive interface, advanced charting tools, and robust algorithmic trading capabilities. It's particularly popular among forex traders who prefer an alternative to the more common MetaTrader platforms. This guide will introduce the essentials […]

April 18, 2024
The Top Skills You Need To Trade Profitably

Elevate Your Trading Game With These Easy-to-learn Skills In the dynamic world of trading, success hinges on your ability to interpret and act on market information. This section delves into the foundational skills of research and analysis, equipping you with the tools to make informed trading decisions. Practical Trading Skills: Research and Analysis Successful trading […]

April 15, 2024
What is a Funded Trading Account

Unlocking Money Making Opportunities for Aspiring Traders Funded trading accounts offer a unique avenue for aspiring traders to enter the markets with significant capital without the associated risks of using their own funds. These accounts are particularly appealing in environments like forex and cryptocurrency trading, where capital requirements can be prohibitive for individual investors. Understanding […]

April 11, 2024
Don’t Fall into the Trading Psychology Trap

Avoiding the Most Common Pitfalls that Trip Up Traders Trading in financial markets, whether it’s stocks, forex, or cryptocurrencies, is not only about crunching numbers and analyzing charts but also about managing your mindset. The psychological aspect of trading is a critical factor that can significantly influence your success or failure. Understanding how emotions and […]

1 2 3
FX2 LLC.
Registry #2694 LLC 2022   |   The Financial Services Centre, Stoney Ground, Kingstown, Saint Vincent and the Grenadines
Code Copied!
linkedin facebook pinterest youtube rss twitter instagram facebook-blank rss-blank linkedin-blank pinterest youtube twitter instagram