Financial Programming Services

A Happy New Year to all clients and friends. I haven't made any updates for a while (I hope 2013 is as busy as 2012!), so to make up I will try to detail some of the behavior that I think every trader (and financial services developer) should consider.

Frame dependence

Frame Dependence is the tendency to evaluate current decisions within the framework in which they have been presented. Look at the screenshot of recent activity of EURUSD on one of my robots. See the long rally which halts, then continues upwards. This presents a frame-dependent choice. One can either decide, "Yes, that's a significant enough rally, I will take profit here", or decide "Nope, let the profits run, I can always exit if it doesn't work out". What is really going on here is how one perceives the trade profit. The thought "Its not mine until it's booked" may lead to "It's only winnings so it's not a problem if I lose it". Account equity becomes account balance only if you have no open winning or losing trades. Frame dependence includes loss aversion ("I don't want to lose my winnings so I'll book them at this level") and hedonic editing ("Wow! If I book now I've made $$$!").

Money illusion (a 2% payrise with 4% inflation is better than a 2% pay cut) also comes into play when trading costs (swap,commission,spread and slippage) are not considered. This further leads one to believe more profit is being captured than actually is. In the screenshot, notice the robot takes the profit, then enters again. As it wins both times, "happy days!", but staying in the trade would have halved the trading costs, plus also of course gaining the difference between the exit of the first trade and the entry of the second.

Hindsight bias

The final statement of the last paragraph can be considered to be made as a result of hindsight. We knew the trades had already been made, we knew the outcome, so we can bemoan the losses incurred, or celebrate the successes. In a manual trading situation, having observed this outcome, if we weigh on the side of "cup half full", we would do the same thing as the robot has done here, and book profit in a similar fashion. If we come down on the "cup half empty" side, we may let the trade run, in the hope of gaining the lost costs. So hindsight may give us a bias for what we do in the future.

Confirmation bias

In scientific experiments, one posits a theory, describes the event or existence of something that would prove the hypothesis, then actively looks for that event or object. If found, the hypothesis is proven, if not, it is not proven.

Confirmation bias is the tendency of people to favor information that confirms their hypotheses. Having observed the events described above, one could look backwards for similar events where 2 such trade events occurred. Seeing the event again could lead one to believe either that the cup was half empty or full.