An attempt to explain toxic trading behavior with Kahneman's Prospect Theory
Jun 08, 2023 at 04:53
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Jun 08, 2023 at 04:53
Hi all,
this is my first post, I hope I put it into the correct sub-forum.
I am fascinated by behavioral finance, and how it can explain many of our trading behaviors. I thought I'd share my thoughts on one of those findings from behavioral finance (Prospect Theory) and how I see it translate into our trading behaviors. I'd be happy to hear your thoughts, ideas, etc. :)
Prospect Theory by Kahnemann and Tversky from 1979 is one of the core pillars of behavioral finance. It has shown such importance, that it was referenced for Kahnemann’s Nobel Prize in Economics in 2002.
I am completely fascinated by Prospect Theory and its far-reaching impact, and I do believe a lot of it can be translated to DayTrading:
What is Prospect Theory though and how can it affect traders in an extremely negative way? Prospect Theory very well explains the core trading error of a majority of traders, but let’s go step-by-step.
Let’s first understand what is Prospect Theory and look at some examples to get a better understanding. Second, deep-dive how it affects us as traders, and third, outline what we as traders can do as countermeasures and thereby improve our trading performance.
Prospect Theory: What does it say?
At its core, Prospect Theory describes that humans tend to apply an asymmetric assessment of potential losses and gains. Kahnemann and Tversky said that “in human decision-making, losses loom larger than gains” (1979).
Still sounds a bit theoretical and hard to grasp, right? Let me walk you through a real experiment that describes the core of Prospect Theory very well.
Imagine the following scenario: You are given two options to choose from:
A) 100% chance to lose 3,000 USD
B) 80% chance to lose 4,000 USD, 20% chance to lose nothing
Which one would you choose?
Next, you have to choose between the following:
C) 100% chance to win 3,000 USD
D) 80% chance to win 4,000 USD, 20% chance to win nothing
Again, which one would you choose?
Interestingly, when asked to choose between A) and B), 92% chose B), so taking the chance to avoid losses. However, when choosing between C) and D) only 20% choose D), meaning only a small number of people would take the risk to win more (note B & D have a prospect of similar risk/ likelihood).
The experiment nicely shows that humans tend to avoid risk when gains are at stake, however are much more willing to take risk to prevent losses (loss aversion).
AGAIN, this is the core here: People show a strong tendency to not take risks when gains are at stake, but are willing to do so if they could avoid losses!
Having understood this, we can apply this to Trading as well!
2. Prospect Theory applied to Trading
Knowing from Prospect Theory that we tend avoid risks when gains are at stake and seek risks if we could prevent losses, we should have a look at our profit-taking, but also our loss-taking behavior. We know that in Trading it is about Cutting our losses early, while letting our profits run in order to have our profits outweigh out losses and be profitable. There are plenty of statements from the best traders in the world outlining this key element of trading.
What do we do in loss trades? According to Prospect Theory, we are willing to take risks to avoid losses. Is this actually good or bad in terms of trading strategy?
It is exactly the opposite of what we should do as traders. If we take additional risks to avoid our losses, that means we do not cut or loss early and move on. We rather show a behavior of taking on additional risk in a trade that is already in loss in order to potentially recover our loss and close it breakeven or in profit. In terms of trading, that means we may adjust our Stop Loss even further away in case we are in a loss trade, thereby not accepting our loss, but gambling higher in order to prevent the loss. This behavior can actually be witnessed with a large amount of traders, and it is extremely toxic to our performance, as we let our loss trades become big.
Tracking this behavior, we can see that is has a significant negative influence on the performance. The moment we know what we need to look at is the moment we can understand the toxic influence on our performance which would otherwise be hidden in our trading data. (see screenshot 1)
On the profit side, we can witness a similar toxic behavior, just instead of letting loss trades become big, we keep our profits small. In Prospect Theory we have seen that we rather take the safe smaller profit instead of taking the risk to grow our win even bigger. In terms of trading, profitable positions are oftentimes manually stopped by the trader even before reaching the initially set Take Profit level. Imagine you are in a trade, which went 1,000 USD in profit already, with a Take Profit set at 2,000 USD. Many traders tend to manually close the trade at 1,000 USD profit, thereby securing their win but forgoing the chance to reach the 2,000 USD profit.
Similarly to the Stop Loss adjustment in loss trades, we can track the manual stops of traders and simulate the individual performance effect of this behavior on our performance (simulates trade outcome if the trader would have not manually stopped the trade in profit). (see screenshot 2)
Doing those two behaviors over and over again, we as traders set ourselves up for failure. It is extremely hard to be profitable overall if we keep our profits small and keep having big losses. However, it is the human tendency to do so as explained in Prospect Theory, and we all are humans, so we as traders have to find ways to adjust our behavior as we otherwise are part of the >85% of traders that are losing money. How can we do that? Let’s have a look in part 3 what we can do:
3. Countermeasures to toxic trading behavior
There might be very individual countermeasures to counteract this typical behavioral tendency, but let’s focus on 3 general ones here which are very powerful and helped me a lot: a) Situational awareness, b) Alternate profit metrics, and c) Leverage technology & alerts. Let’s get into what those are:
a) Situational Awareness
I believe by reading and getting to know about the behavioral biases underlying our trading decisions, we are already doing the first step. Behavioral biases and fallacies are unconscious in nature, hence we do not recognize this specific behavior with ourselves as it feels natural. The first step in working on the impact of those biases in trading is to recognize our own behavior and be able to make sense of it. The next time we are adjusting your Stop Loss or manually close a profit trade early, we may first recognize that you now did something likely counterproductive to your performance and secondly, will hopefully be able to make sense of our own behavior by understanding Prospect Theory. Adjusting trading behaviors is not an instant process, it always starts with understanding, recognizing, and then step-by-step adjustments.
b) Alternate profit metrics
Much of the trading behaviors we show are closely interlinked with how we value money, and the Prospect Theory is a very good example for this. Follow-up studies have actually shown a weakened effect of loss aversion with increased wealth, however this would go a bit beyond this post and it's already very long :) Kahnemann and Tversky argued in their Prospect Theory, that losses hurt 2–2.5 times as much compared to the pleasure equivalent gains, which explains much of our actual behavior. In order to soften this effect, and thereby also achieve a more rational behavior, as traders we can move away from thinking in currency terms (such as US Dollar), but rather think in other metrics such as risk or points/ pips. Instead of thinking we lost 2,000 USD on a trade, we can equate the 2,000 USD as 1R (risk). If we adjust our Stop Loss to 3,000 USD, we may lose 1.5R, if we win 4,000 USD, we win 2R, and so on. By doing so, we move away from our value of money, move away from the pain of losing money, and move away from the pleasure of winning money. However, as we learnt the pain is larger for losses compared to the equivalent pleasure from wins, so eliminating or reducing this pain and pleasure is actually doing us a favor, both emotionally as well as behaviorally.
c) Leverage technology & alerts
Nowadays, traders can enjoy a great level of support during their trading by leveraging technology and software targeted at identifying those destructive trading behaviors. Hoc-trade is one of those tools, and as seen in the previous chapter, it measures exactly the kind of behaviors which can be explained with Prospect Theory. In case destructive behaviors are identified one will receive a near real-time alert in case you have adjusted your Stop Loss again or just manually closed a profit trade.
While you can identify those behaviors and also will receive alerts to support you during trading with technology, it still requires you as the trader to make trading decisions. Therefore, technology can be seen as a great help which can give you an edge over other traders, but you will still need to understand, recognize, and alternate your behavior in order to utilize the full effect on your trading performance.
A quick closing remark:
Behavioral economics/ finance is a fascinating field with incredibly valuable insights for trading. A majority of our oftentimes destructive behaviors can be explained by biases and fallacies, and the Prospect Theory is truly one of the most important ones. It covers our behavior at the heart of trading strategies, growing large profits while keeping our losses tight.
I would like to close this post with 2 quotes, the first from one of the best traders in the world, and the second from likely the best investor in the world. Both quotes clearly outline how crucial it is to follow what we have discussed in this post: Cut your losses early…
Quote 1: Ed Seykota, Trader:
“The elements of good trading are 1) cutting losses, 2) cutting losses, and 3) cutting losses*. If you can follow these three rules, you may have a chance.”*
…and let your profits run!
Quote 2: Warren Buffet, Berkshire Hathaway
“When it’s raining gold, reach for a bucket, not a thimble”
Happy Trading and stay safe!
this is my first post, I hope I put it into the correct sub-forum.
I am fascinated by behavioral finance, and how it can explain many of our trading behaviors. I thought I'd share my thoughts on one of those findings from behavioral finance (Prospect Theory) and how I see it translate into our trading behaviors. I'd be happy to hear your thoughts, ideas, etc. :)
Prospect Theory by Kahnemann and Tversky from 1979 is one of the core pillars of behavioral finance. It has shown such importance, that it was referenced for Kahnemann’s Nobel Prize in Economics in 2002.
I am completely fascinated by Prospect Theory and its far-reaching impact, and I do believe a lot of it can be translated to DayTrading:
What is Prospect Theory though and how can it affect traders in an extremely negative way? Prospect Theory very well explains the core trading error of a majority of traders, but let’s go step-by-step.
Let’s first understand what is Prospect Theory and look at some examples to get a better understanding. Second, deep-dive how it affects us as traders, and third, outline what we as traders can do as countermeasures and thereby improve our trading performance.
Prospect Theory: What does it say?
At its core, Prospect Theory describes that humans tend to apply an asymmetric assessment of potential losses and gains. Kahnemann and Tversky said that “in human decision-making, losses loom larger than gains” (1979).
Still sounds a bit theoretical and hard to grasp, right? Let me walk you through a real experiment that describes the core of Prospect Theory very well.
Imagine the following scenario: You are given two options to choose from:
A) 100% chance to lose 3,000 USD
B) 80% chance to lose 4,000 USD, 20% chance to lose nothing
Which one would you choose?
Next, you have to choose between the following:
C) 100% chance to win 3,000 USD
D) 80% chance to win 4,000 USD, 20% chance to win nothing
Again, which one would you choose?
Interestingly, when asked to choose between A) and B), 92% chose B), so taking the chance to avoid losses. However, when choosing between C) and D) only 20% choose D), meaning only a small number of people would take the risk to win more (note B & D have a prospect of similar risk/ likelihood).
The experiment nicely shows that humans tend to avoid risk when gains are at stake, however are much more willing to take risk to prevent losses (loss aversion).
AGAIN, this is the core here: People show a strong tendency to not take risks when gains are at stake, but are willing to do so if they could avoid losses!
Having understood this, we can apply this to Trading as well!
2. Prospect Theory applied to Trading
Knowing from Prospect Theory that we tend avoid risks when gains are at stake and seek risks if we could prevent losses, we should have a look at our profit-taking, but also our loss-taking behavior. We know that in Trading it is about Cutting our losses early, while letting our profits run in order to have our profits outweigh out losses and be profitable. There are plenty of statements from the best traders in the world outlining this key element of trading.
What do we do in loss trades? According to Prospect Theory, we are willing to take risks to avoid losses. Is this actually good or bad in terms of trading strategy?
It is exactly the opposite of what we should do as traders. If we take additional risks to avoid our losses, that means we do not cut or loss early and move on. We rather show a behavior of taking on additional risk in a trade that is already in loss in order to potentially recover our loss and close it breakeven or in profit. In terms of trading, that means we may adjust our Stop Loss even further away in case we are in a loss trade, thereby not accepting our loss, but gambling higher in order to prevent the loss. This behavior can actually be witnessed with a large amount of traders, and it is extremely toxic to our performance, as we let our loss trades become big.
Tracking this behavior, we can see that is has a significant negative influence on the performance. The moment we know what we need to look at is the moment we can understand the toxic influence on our performance which would otherwise be hidden in our trading data. (see screenshot 1)
On the profit side, we can witness a similar toxic behavior, just instead of letting loss trades become big, we keep our profits small. In Prospect Theory we have seen that we rather take the safe smaller profit instead of taking the risk to grow our win even bigger. In terms of trading, profitable positions are oftentimes manually stopped by the trader even before reaching the initially set Take Profit level. Imagine you are in a trade, which went 1,000 USD in profit already, with a Take Profit set at 2,000 USD. Many traders tend to manually close the trade at 1,000 USD profit, thereby securing their win but forgoing the chance to reach the 2,000 USD profit.
Similarly to the Stop Loss adjustment in loss trades, we can track the manual stops of traders and simulate the individual performance effect of this behavior on our performance (simulates trade outcome if the trader would have not manually stopped the trade in profit). (see screenshot 2)
Doing those two behaviors over and over again, we as traders set ourselves up for failure. It is extremely hard to be profitable overall if we keep our profits small and keep having big losses. However, it is the human tendency to do so as explained in Prospect Theory, and we all are humans, so we as traders have to find ways to adjust our behavior as we otherwise are part of the >85% of traders that are losing money. How can we do that? Let’s have a look in part 3 what we can do:
3. Countermeasures to toxic trading behavior
There might be very individual countermeasures to counteract this typical behavioral tendency, but let’s focus on 3 general ones here which are very powerful and helped me a lot: a) Situational awareness, b) Alternate profit metrics, and c) Leverage technology & alerts. Let’s get into what those are:
a) Situational Awareness
I believe by reading and getting to know about the behavioral biases underlying our trading decisions, we are already doing the first step. Behavioral biases and fallacies are unconscious in nature, hence we do not recognize this specific behavior with ourselves as it feels natural. The first step in working on the impact of those biases in trading is to recognize our own behavior and be able to make sense of it. The next time we are adjusting your Stop Loss or manually close a profit trade early, we may first recognize that you now did something likely counterproductive to your performance and secondly, will hopefully be able to make sense of our own behavior by understanding Prospect Theory. Adjusting trading behaviors is not an instant process, it always starts with understanding, recognizing, and then step-by-step adjustments.
b) Alternate profit metrics
Much of the trading behaviors we show are closely interlinked with how we value money, and the Prospect Theory is a very good example for this. Follow-up studies have actually shown a weakened effect of loss aversion with increased wealth, however this would go a bit beyond this post and it's already very long :) Kahnemann and Tversky argued in their Prospect Theory, that losses hurt 2–2.5 times as much compared to the pleasure equivalent gains, which explains much of our actual behavior. In order to soften this effect, and thereby also achieve a more rational behavior, as traders we can move away from thinking in currency terms (such as US Dollar), but rather think in other metrics such as risk or points/ pips. Instead of thinking we lost 2,000 USD on a trade, we can equate the 2,000 USD as 1R (risk). If we adjust our Stop Loss to 3,000 USD, we may lose 1.5R, if we win 4,000 USD, we win 2R, and so on. By doing so, we move away from our value of money, move away from the pain of losing money, and move away from the pleasure of winning money. However, as we learnt the pain is larger for losses compared to the equivalent pleasure from wins, so eliminating or reducing this pain and pleasure is actually doing us a favor, both emotionally as well as behaviorally.
c) Leverage technology & alerts
Nowadays, traders can enjoy a great level of support during their trading by leveraging technology and software targeted at identifying those destructive trading behaviors. Hoc-trade is one of those tools, and as seen in the previous chapter, it measures exactly the kind of behaviors which can be explained with Prospect Theory. In case destructive behaviors are identified one will receive a near real-time alert in case you have adjusted your Stop Loss again or just manually closed a profit trade.
While you can identify those behaviors and also will receive alerts to support you during trading with technology, it still requires you as the trader to make trading decisions. Therefore, technology can be seen as a great help which can give you an edge over other traders, but you will still need to understand, recognize, and alternate your behavior in order to utilize the full effect on your trading performance.
A quick closing remark:
Behavioral economics/ finance is a fascinating field with incredibly valuable insights for trading. A majority of our oftentimes destructive behaviors can be explained by biases and fallacies, and the Prospect Theory is truly one of the most important ones. It covers our behavior at the heart of trading strategies, growing large profits while keeping our losses tight.
I would like to close this post with 2 quotes, the first from one of the best traders in the world, and the second from likely the best investor in the world. Both quotes clearly outline how crucial it is to follow what we have discussed in this post: Cut your losses early…
Quote 1: Ed Seykota, Trader:
“The elements of good trading are 1) cutting losses, 2) cutting losses, and 3) cutting losses*. If you can follow these three rules, you may have a chance.”*
…and let your profits run!
Quote 2: Warren Buffet, Berkshire Hathaway
“When it’s raining gold, reach for a bucket, not a thimble”
Happy Trading and stay safe!
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