Beware of selection bias when designing your forex trading strategy. (Or, how wishful is your thinking?)

An important principle to keep in mind when putting together a forex strategy is the need to avoid bias (aka wishful thinking) from affecting your judgment about what constitutes a signal, a chart pattern, or a trend. In science this is often called the "file drawer problem", referring to the fact that researchers may consciously or unconsciously relegate data that conflicts with their experimental hypothesis to a file drawer, thereby skewing the results of their research toward the conclusion they'd like to be true.

Let's say you're evaluating a chart-based trading system and looking back through old charts to see what happened in the past when it signalled trades. Are you paying equal attention to the times it failed and yielded a loss? Are you adding up these losses consistently and factoring them into the system's overall trading results? Or are you finding subtle ways to discount these failures, and judging them on a different standard than the successes?

For example, do you tell yourself "I would've gotten out of that trade quickly anyway, since it would have been obvious it was going the wrong direction"? Or "This one doesn't really count as a signal because it only crossed over for a very short period." Or "I would've sold when it spiked up like that, before it crashed back down for a loss." And so on...there are an almost infinite number of ways you can shape the data to convince yourself it's a viable forex system. It's human nature - though certainly one of its more troublesome aspects.

You owe it to yourself and your trading account to maintain strict standards, with as little wiggle room as possible, when deciding whether a currency trading strategy is likely to work for you. Believe me, it's a lot better than finding out the hard way.

Related topics:
Common Errors When Designing a Trading Strategy
Don't Let Your Charts Deceive You