Endless explanation is given to justify the S&P 500’s persistent advance over these past months and years. Yet, would the same speculators that throw in with the advance be so willing to follow the trend if the S&P 500 were in an equivalent dive? Direction can have an irrational influence on our market views and we discuss that bias in today’s Quick Take video.
Talking Points:
- There are many cognitive biases that can influence how we perceive and interact with markets
- For many that are unfamiliar with markets and trading, the concept that something that depreciates can add profit does not compute
- Justifications made for continuation or reversal on a 'clear' trend like the S&P 500's often evaporate when you flip the chart
Interested in learning more about how our every-day psychology can influence our trading for the worst? Download the Building Confidence in Trading and Traits of Successful Traders guides on the DailyFX Guides page.
There are a laundry list of cognitive biases that most humans employ without even knowing it. In a fight-or-flight situation or the normal course of social interaction, these psychological triggers help make us efficient and avoid risks (both real and perceived). However, in our investment and trading, many of these harmless skews in perception can weigh materially on our profitability. Having taught a number of people to trade over the years, one of the more interesting gaps in comprehension that I've witnessed is the ability to understand how 'shorting' (short sales) in capital markets can confer value. There are very few corollaries in normal life where something's value diminishes and a profit is derived.
A difficulty in grasping a short view on the market carries over often to trading FX. When you take a position in a spot exchange rate, you are in fact placing both a long and short position on two separate currencies. This may seem unique to trading FX, but in fact, there is a relative exposure to all trades placed in all assets. Whether a currency cross, a use of leverage for exposure or just opportunity cost; there is always a counterbalance - and that is how we in turn evaluate the value of the gain or loss made. What I find even more remarkable and underappreciated is the very fact that the orientation of a chart itself can significantly alter our evaluation of conviction and direction.
The S&P 500 is remarkable example of a persistent trend whereby value is called into question, but skepticism is held at bay by opportune justification. Yet, what if we were to flip the equity index upside down? The trend is exactly the same in pace and consistency, but the orientation simply changes. For many, if the chart is inverted; the sense of persistent trend starts to look more like a burgeoning reversal candidate. That may be due to the perception that a lower bearing equates to a cheaper investment which in turn finds automatic association to value. Yet, the 'why' doesn't matter so much as the fact that it does occur. Not everyone may find - or admit - that this shift of the chart alters their view - but I know it still has an irrational influence on me. We can take it further and flip FX pairs that more readily have an equilibrium that does not depend on direction. Does USD/JPY look different than JPY/USD or EUR/USD compared to USD/EUR. A step further, what if two assets have a strong and persistent correlation (like EUR/USD and USD/CHF) yet we come to a different conclusion for their technical bearings? We discuss an interesting cognitive bias and the best way to account for it in today's Quick Take Video.
To receive John’s analysis directly via email, please SIGN UP HERE
