It's All In How You ‘Frame’ It

09/12/2014 6:00 am EST

Focus: STRATEGIES

Trader David Blair of TheCrosshairsTrader.com highlights the importance of ‘framing’ when it comes to making trading decisions and cites several examples to illustrate the point.

Whether we believe it or not, we tend to choose different options for the same problem depending on the way the problem is presented and whether or not the problem is presented as a loss (negative) or a gain (positive).  This is known as ‘framing’ and is just one of many cognitive biases we face in our day-to-day decision making.  As an example, let’s suppose a physician informed you that a suggested surgical procedure has a 95% survival rate and will require several months of strict adherence to a rehabilitation protocol.   You consider this to be pretty good odds when framed in the positive (95% success rate) and when you are more than willing to dedicate the time required for recovery.  But what if the physician informed you that the procedure is complicated, will require months of disciplined rehabilitation, and there is a 5% chance you will not survive the procedure?  When framed in the negative, we tend to make different decisions even though the odds of failure are the same (5%) in both cases.

And how about the stock market?  How does framing affect our decision making process when considering taking trading risks?  If you were to read where a particular chart pattern is profitable 72% of the time over the last 20 years (positive framing) you would most likely consider that to be pretty good odds.  However, if another study reveals that when this pattern does not work, the percentage loss is much greater than the potential gain (negative framing) would you still be comfortable with the odds?  What if you found that trading the false move (the 28% of the time) would have been more profitable?  How would you feel then?

What about the financial headlines?  Our thinking is easily susceptible to framing every single day when we read headlines such as Gold Sells Off As Ukrainian Tensions Ease, which implies that gold is weak because of easing Ukrainian tensions.  We may then make our gold related trading decisions based on Ukrainian tensions only to find the next day’s headline reads Gold Sells Off In Spite of Heightened Ukrainian Tensions.  So, now gold weakness is not related to the Ukrainian crises?  You get the idea.  It is all in how you frame it.

By David Blair of TheCrosshairsTrader.com

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