The Risk of Trading: Mastering the Most Important Element in Financial Speculation

CHALLENGES WITH CONFIRMATION BIAS

Conditional probability is defined as the chance of something occurring given an occurrence of another event. If the speed limit was raised by 50 percent, for sure there will be a greater overall increase in accidents. The markets have the same effect. Perhaps it's a simple candlestick bar trend change or price pattern that establishes a new trend or a volume spike. In fact, most who follow any form of technical analysis are basing their trading on conditional probability. In other words, when something occurs, the premonition is that another event will occur. Conditional probability doesn't tell us that it will occur, but rather that there is a greater possibility that it will occur.

Many traders tend to assume conditional probabilities when in actuality there is no long-term data evidence to support such theories. One oddity of human nature is that we tend to recognize information that supports our idea and ignore data that conflict with it. A standard part of my mentorship program was to have a trader review his or her current trade setups over a period of time using historical charts. My goal was to determine if there was any evidence of “confirmation bias” in the trader's assessment. The trader would scroll through time charts indicating evidence of a setup and eventual outcome. In nearly all cases the traders found a way to validate their findings and simply overlooked some setups where it would have had a negative outcome. I too would perform ...