While trading, directional bias is a concept that comes up very often. Trading with a directional bias means trading based off of assumptions about market movements due to market expenses or important news releases. For market expenses, traders want to sell when the market hits a certain point because they assume the market trend will soon come to an end. Similarly, in the case of important news releases, the concept is that traders assume specific news will only push the market to move in a certain direction. However, while trading it is crucial to remember that assumptions need to be tested before running with them. (for more information on this, check out our case study: “Unemployment Rate And Its Effect On The S&P 500: It’s Less Intuitive Than You Think”)
There are two types of news that influence the market -expected and unexpected news. While both of these types of news influence the market, it’s impossible to have directional bias for unexpected news. In our opinion, it is the expected news that has a risk of being biased because there are established theories as to how the markets will react. Issues of bias like these arise when markets are no longer acting logically. As a trader, one must always be looking for new signals and information on how and why the market is moving. Successful traders do not trade solely off of their own ideas, rather they constantly taking in new information and formulating an up to date trading strategy.
Avoiding directional bias
If traders truly want to avoid directional bias they can begin by looking at their last five trades. If one finds that each of their last five trades have been on the same side of the market (either short or long) and were not successful then it’s time to reevaluate one’s trading strategy.
In the case of expected news, the release will have a positive or negative affect on the market. Important numbers to consider within these releases are the expected value and the actual value which can generate a magnitude of surprise that may be either positive or negative.
As mentioned before, directional bias is dangerous because markets can often behave illogically. For example, if an event release is negative, it would be reasonable to believe that the stock market will move down, but that is not always the case. One way to prepare for news releases that can affect the market is to use a backtester. Read our case study “How to Prepare for Economic Events” to understand the significance of using a backtester.
By using a backtester traders will be better equipped with the tools they need to avoid directional bias.
Fight the urge to only be rational
As a regular person, it is easy to decide what is rational and what is not. However, a smart trader does not simply decide what is rational; instead, they wait and see how the market moves on its own in order to form an educated opinion. As humans we are logical beings, so being patient in this scenario is easier said than done. However, while we are trading, we also have to fight the urge to do things that might appear to be rational on the surface, but are actually detrimental to our end goals. A trading tool that we can use in order to avoid mistakes is the backtester, a technological resource that helps us make more objective logical decisions.
Today, there are many backtesting tools and algorithms that allow traders to understand what the current market situation is in real time. These tools also allow traders to compare the current market situation to that of similar situations in the past which keeps traders away from directional bias. As Jose A., an FX trader, says, “I think this has the most accurate and helpful analysis of Forex Trading“. The BetterTrader backtester has the ability to assist a trader as if they have a full team of analysts at their side checking how the market has reacted in similar situations in the past.
For more information regarding how to use our backtester, check out our relevant case studies: https://bettertrader.co/case-studies/.