Overcoming Functional Fixedness and Biases for Profitable Trades

Functional Fixedness

This cognitive bias is not much discussed in the trading world; however, I believe it affects derivative traders significantly.

I’ll explain the concept of functional fixedness to you and how it applies to trading.

Functional Fixedness is a cognitive bias which can lead to limitations in how we think about objects. We are conditioned to use certain items for tasks, such as thinking of a screwdriver for tightening screws. However, there are many creative solutions that could be used when looking at problems outside the box; a simple spoon can also do the job!

Functional Fixedness can be a barrier to creative thinking when trading. For instance, take the classic example.

With Rs.100,000/- in your trading account, you have spotted a favorable trade in Nifty and anticipate to extend the position for 2 or 3 days. ‘NRML’ is the product type you will go for as it is suitable when overnight holding is required. The margin requirement will be roughly Rs 65,000/-.

At 3:20 PM a trade is taken and this will block 65K of your funds as margin. 45K will be available in your balance, allowing you to potentially invest in more trades the next day.

When the market opens the next day, Nifty proceeds as expected and you are delighted with the outcomes.

If you spot a good intraday opportunity in TCS stock futures, but only have an available margin of 45K and the MIS margin for the trade requires 60K, then you won’t be able to take advantage of that particular intraday trade. You’d have to find 15K more in order to pursue it.

This is where functional fixedness takes over; we think of NRML (margins blocked for overnight positions) only as ‘margins blocked’, and consequently overlook this capital until the position is settled.

A bit of creative thinking, combined with some effort, enables us to maintain our overnight position while taking advantage of the intraday opportunity.

Here is how it would work –

At the beginning of the day, you have a margin of 45K, not enough to perform an intraday trade.

By changing your NRML Nifty position to MIS, you can unlock 39K from the 65K that was previously blocked as MIS for Nifty is around 26K.

You have a sum of 84K (45K + 39K) free cash to use for the day.

By investing 84K, you can easily free up 60K for an MIS order, leaving 14K as available margin.

At the end of the day, it’s important to square off your MIS stock futures trade; this was an intraday transaction.

The maximum margin available to you is 84K.

Convert the MIS Nifty trade to an NRML position and carry it over.

– Confirmation Bias

Take a glance at Tata Motor’s below: 

This chart contains some key points which I have marked.

Let’s assume the stock is around 430

It appears that 430 is a key price level, based on past price movements.

Later, the price soared through 430 before plummeting to 370.

The stock price remained steady around 370, demonstrated by the double/triple bottom formation.

Since 370, the price has been on an upward trajectory, culminating in the current stock price of 430.

It appears the stock is ready to go up – what do you think?

Let’s say there was some news headlines on that day- 

Chances are that this news item will cause you to think that Tata Motors is ready to climb, aiding the wisdom behind your decision to purchase the stock. Despite this, however, it is unlikely that the basics here could truly be a powerful motivator for the stock’s price rising. Nonetheless, at an unconscious level, one can start searching for data that upholds their belief. In other words, no matter what occurs, when you form a trading opinion you will only pay attention to material which backs up your first opinion – your brain won’t notice any details which contradict it.

This phenomenon is referred to as the ‘Confirmation Bias’.

To escape confirmation bias, it is vital to think critically. 

– Attribution Bias

Have you ever had a successful position that made you thrilled with your analysis? Maybe you bought an option and it gained 100% of the cost or perhaps purchased a stock which has had remarkable growth.

Whenever you turn a profit, congratulations are in order. But if things don’t go as planned, how do you respond? It’s important to have a strategy for dealing with loss as well.

Having worked in the stockbroking world, I can confidently say that when investors lose money, they almost always blame their broker. Traders will come up with any number of excuses why it’s not their fault – a glitch in the system, sluggish charts, delayed orders and so on.

It’s mainly the broker’s fault, not the initial bad analysis.

The ‘Attribution Bias’ is something many people are guilty of but it can be combatted. Maintaining a trading journal and noting why you entered and exited trades can help provide great insight into your trading behaviour over time.