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
December 13, 2023
How to Calculate Position Size When Forex Trading

What is a trade size position in forex? How to calculate forex lot size? What is the formula for forex position size? Read more about position size calculation on the FX2 blog.

October 23, 2023
How to Handle Drawdown in Trading

Why is it important to measure the drawdown? What is the drawdown formula? How to reduce drawdown in Forex? Find out tips in our article on the FX2 Blog.

August 25, 2023
What Is Market Noise and How to Trade Without It?

What is market noise, and how can you remove it? Read about trading indicators, charts, and other tools for breaking down and avoiding market noise in trading.

August 14, 2023
How to Trade with Fractals: Step-by-Step Guide

Read about using fractal indicator in trading. Our experts explained a possible fractal trading strategy for your best outcomes. Learn how to trade with fractals on the FX2 Blog.

July 26, 2023
How to Trade Breakouts

Are you thinking about using the breakout strategy? Check out tips on breakouts trading from our experts on FX2 Blog. Read about false breakouts and build your winning strategy.

July 19, 2023
How to Trade Forex on News

Read about news impact on Forex. How to understand forex news? Explore how to trade the news in Forex market: trading strategy from our experts on the FX2 Blog.

July 16, 2023
Stop-Loss Orders Guide

What is a stop-loss and how to use it? How to determine stop-loss and where to set it? Difference between the stop loss and stop limit on the FX2 Blog.

July 3, 2023
How to Trade CFDs: A Step-by-Step Guide

How to trade CFD? What Can be traded as CFDs? We answer your questions about CFDs trading in our article on the FX2 Blog.

June 13, 2023
Psychology Tips to Trade Confidently

Read about emotions in trading and check out how can you master your trading psychology. Build your trading confidence with our tips on trading psychology.

May 24, 2023
Best Technical Indicators for Swing Trading

Check out the best indicators for swing trading in our article and trade with maximum profits. Top technical indicators for swing trading on the FX2 Blog.

linkedin facebook pinterest youtube rss twitter instagram facebook-blank rss-blank linkedin-blank pinterest youtube twitter instagram