You Shouldn't Look At Charts During Trading!
When it comes to trading research and identifying rules, the chart can be a powerful tool. It can give traders the insight they need to make sound decisions and maximize their profits. Unfortunately, it can also lead to visual and cognitive biases that could potentially have disastrous consequences when used in real-time for trading.
We understand this is a contrarian viewpoint as most traders advocate looking at charts to decide whether to enter a trade. But let's look at why this is a fallacy.
We like to repeat Mark Douglas' words from his groundbreaking book on trading psychology: Trading in the Zone.
Many of the new ways in which you will learn to express yourself will be in direct conflict with ideas and beliefs you presently hold about the nature of trading. You may or may not already be aware of some of these beliefs. In any case, what you currently hold to be true about the nature of trading will argue to keep things just the way they are, in spite of your frustrations and unsatisfying results.
What Is A Visual Bias?
A visual bias is when someone interprets data inaccurately because of how it is presented on a chart. This often happens when people are faced with too much information or when they are not sure what the chart is telling them. In these cases, some may rely on their own preconceived notions about the market or try to make sense of the data using emotions rather than an objective analysis.
What Is A Cognitive Bias?
Cognitive biases refer to the mental shortcuts we take when making decisions or interpreting information. A cognitive bias is when someone draws inaccurate conclusions based on limited information or incorrect assumptions. We often rely on our experiences, preferences, and beliefs to make decisions without considering all the facts. For example, a trader may simply rely on recent past experience rather than current data when deciding what stocks to buy or sell. If someone has had success with a trade in the recent past, they may assume that it will work again in the future, or if something has gone against them recently, they may be fearful of taking a bet.
Studies have found that these biases can lead to poor decision-making and an increased likelihood of losses due to incorrect assumptions and inaccurate interpretations of data. Furthermore, these biases are more likely to occur in inexperienced traders who may not be familiar with sophisticated analysis methods such as technical analysis. But even some experienced traders can make errors in interpreting real-time data because trading is emotionally stressful, no matter how much people claim they trade emotion-free. This is why hedge funds have psychologists on their teams who help traders deal with trading anxiety. If you have watched the show Billions, you will identify with the character of Wendy. Coaches like Jared Tendler, the author of the Mental Game of Trading, and Denise Shull, the author of the Market Mind Games, help professional traders.
There is another factor that plays when it comes to making fast discretionary decision-making.
What Is The Amygdala And How Does It Affect Decision-Making?
The amygdala is a small, almond-shaped structure located in the temporal lobe of the brain. It plays an important role in processing emotions, memory, sensory input, and making fast decisions with the primary objective of keeping us safe. This is one of the sources of instant fear responses or anxiety triggers when in an uncertain environment. In pre-historic times this was important to generate fight or flight responses for survival when humans lived in the wild.
The amygdala is responsible for our "gut feeling" when making decisions quickly. It helps us make snap judgments based on past experiences or emotional responses. In other words, it allows us to make decisions without having to process all of the available information.
The faster a decision is made, the more role the amygdala plays. But the problem is that it is a memory-based system that generates emotional responses using sensory input and not the analytical part of the brain - which takes time to process information and facts.
So, what does it all have to do with looking at charts during trading?
Two things generate natural anxiety in humans - health and wealth. So when money is involved and in an uncertain environment like the financial markets, it is quite natural to have a heightened anxiety level. The level of anxiety can be different in different traders based on their experience. In new traders, it is much higher than experienced traders.
As such, the amygdala is already activated and interfering in trading. When using charts directly plays on the amygdala as it creates a visual sensory input. This immediately kicks in the visual biases and cognitive biases. So more often than not, people see in the charts "what they want to see." These make the decision-making emotional and not rational, leading to errors and incorrect conclusions.
In addition to that the daily market volatility also elevates this anxiety and impairs the decision-making further.
Again quoting Mark Douglas from Trading in the Zone
You will need to learn how to adjust your attitudes and beliefs about trading in such a way that you can trade without the slightest bit of fear, but at the same time keep a framework in place that does not allow you to become reckless.
We leverage the logical and analytical brain. The human brain does great in analysis when there is sufficient time, and it is not threatened by the environment. This is why one should study historical charts when researching trade setups and identifying trading rules. This is an offline process and is iterative and time-consuming.
Once these rules are identified, one should backtest them under different market regimes to understand the performance boundaries. These should also be forward tested as in the financial markets, past performance doesn't guarantee future results.
If the results look satisfactory, one should codify the rules to trigger entry and exit alerts that one can simply act on during live markets. Doesn't matter whether one is a technical trader, fundamentals trader, or quantamental trader; creating trading systems to make decisions is the way to trade in a consistent, bias-free, and emotions-neutral way. Of course, one should always do a post-analysis of trades from their trading system to ensure that it continues to perform well or make changes as appropriate to adjust to changing market environments. But again, these are offline processes and not real-time.
Now, we are not saying that everyone should avoid charts during trading. In fact, expert traders do use them regularly, but it takes years and often decades of practice to look at charts objectively during live trading and make sound analytical decisions. But for other traders, especially new traders, the trading systems way is the way to inverse the metric that says 90-95% of traders fail.
There is a reason why 60-73% of trading in the US markets happens algorithmically. There are no traders looking at charts in the real-time to make these trading decisions. But the creators of these platforms definitely use all the tools including charting tools when it comes to designing these trading systems.
What if you don't know how to code?
This is where Researchfin.ai comes in. We will be launching our no-code Trading Systems platform soon for everyone.
Researchfin.ai makes it extremely easy for anyone to learn, research, test, and deploy trading systems powered by AI and Machine Learning, irrespective of their trading and coding experience. We provide a rich set of trading system templates anyone can use to get started. We have the most powerful real-time scanning functions available in any software. Whether you are a stock market, forex, or crypto trader, we make it extremely easy for you to define your setup, entry, and exit rules.
Sign-up for an invite on our website if you haven't already done so.