Friday, March 5, 2010

Frame Dependence

How we behave when trading is dramatically affected by how we frame things. "Frame dependence" is the term that addresses this. The framing we apply causes our behavior in any given situation. There are cognitive and emotional aspects involved. The cognitive aspects have to do with how people organize information and the emotional aspects have to do with how they feel about that information.

An example, offered by Hersh Shefrin in his book, Beyond Greed and Fear, has to do with someone buying a stock which immediately goes down. As soon as it comes back to the purchase price they sell it because they're defining the frame relative to the purchase price instead of mark to market. You could say, "Well, yeah, I don't want to lose money," but the issue is more subtle than that. If the last time you watched a trade move into negative pips, return to break even and you stayed in, only to incur a loss in the end, you're going to be more inclined to get out the next time it happens. Your recent experience is having an impact on this new decision.

Each decision to act on a trade has to be taken anew, unaffected by the last time. This is much easier to do if you have an overall philosophy of trading or a consistent approach that you follow. It's the reason I can go long in a pair, as I did in the Euro and GBPJPY yesterday, even though I believe they're overall weak. Trade the market where it is, unbiased by behavioral biases.
© Dianne Fecteau, 2010. No part of this material may be reproduced in any form, or referred to in any other publication, without the express written permission of the author.

My purpose in writing this blog is to show you how one trader, me, makes trading decisions and survives while trading Forex. One of the biggest problems I had when I first started trading was trying to apply the “rules” to actual trades. Another was the psychology—limiting losses and letting profits run. If you study my blog, you’ll see how I deal with both those issues. So my writings are not trade recommendations but rather educational in purpose. You have to decide on your own approach to trading. Remember that trading is risky.

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