Most people display a stubborn streak at times, but in trading, refusing to budge from a position is known as an anchoring bias. This is when traders fixate on one main piece of information (the anchor) to make a decision even when at times it can mean fighting against the market.
Anchoring occurs in many day-to-day situations with one of the best examples being Black Friday. Marketing information tells consumers how much something should cost and then offers a deep discount. Much of the value that customers perceive is based on little more than anchoring.
Several ground-breaking studies by Kahneman and Tversky in the 1970s explained the effect of anchoring. They were interested in how people formed judgements when they were unsure of the facts. They found that when people are uncertain about the correct answer, they take a guess using the most recent number they’ve heard as a starting point.
Various studies have shown that even when people are told that the data they’ve previously heard is wrong or irrelevant it is still incredibly difficult to avoid factoring it into decisions.
Anchoring bias in trading
Traders exhibiting this bias are often influenced by their initial opinions, the initial trend, a stock on which they have made a profit in a previous trade or arbitrary price levels such as their entry or target prices. They are prone to clinging to these numbers when making their investment decisions.
It is, therefore, important to strike a balance: you must use past information for supportive research, but you must also react to the moving market. Giving too much weight to the first piece of information offered can lead to serious miscalculations if not risk-managed properly.
Anchoring also means that traders might discount underlying fundamentals about a stock price or fail to act when a trend is reversed. This reluctance to change their position means they can ride price falls to the bottom and suffer massive losses as a result.
One way to take this psychological bias out of trading is by adopting a stop loss strategy. Using a stop loss means you automatically close a losing position that you might have otherwise let run.
Stop loss management
A stop loss order attempts to prevent traders from hanging on to losing trades by being anchored to an original buy price. It is a protective mechanism that flags up when a trader should take the hit on a small loss before the price drops any further.
Analysts are torn on the merits of stop loss orders. On one hand, they provide a safety net to exit a trade once its movement begins to lose money. Yet, deciding where to set the stop order can be a tricky concept and it relies on a trader’s ability to assess how and when that limit might be triggered.
Some traders will also increase the stop-loss or cancel it when the price approaches the level set, hoping to allow the market to return to the opening level. Yet this is just another form of anchoring and should be avoided. It is important to learn how to calculate a stop loss accurately, and then stick to it.
The percentage method
The percentage method for setting stop losses is popular because it is simple. This is done by determining the percentage of the stock price a trader is willing to give up before they exit the trade.
Setting it at 10% of its value means that if the stock is trading at £50 per share, the stop loss would be set at £45 - £5 below the current market price of the stock.