What is the hot-hand fallacy?
The hot-hand fallacy in trading is a cognitive bias that causes traders to assume a winning streak is likely to continue, even if there are indications to the contrary. After closing a successful position, a trader may follow up with another trade, hoping to capture further gains.
In this guide, we will look at the hot-hand fallacy definition with real-life trading examples as well as reveal tactics that may help to avoid this behavioural pitfall.
Key takeaways
The hot-hand fallacy makes traders believe that after one successful trade another one will follow.
This cognitive bias happens because of people’s tendency to seek patterns and base judgements on insufficient sample sizes.
The hot-hand fallacy may cause excessive risk-taking, irrational decision, and confirmation bias.
To avoid hot-hand fallacy traders may consider carrying out thorough research, keeping a trading diary, seeking feedback and acknowledging the existence of the bias.
Hot-hand fallacy explained
The term “hot hand” originated in the US and refers to basketball slang. The idea is that a player who successfully scores a basket will be able to score again with his next shot. In other words, they have a hot hand.
The hot-hand fallacy originated in 1985, when behavioural scientists Thomas Gilovich, Robert Vallone and Amos Tversky, also referred to as GVT, published a paper entitled “The hot hand in basketball: On the misperception of random sequences” in the Cognitive Psychology journal.
The study aimed to demonstrate that people were wrong in making the assumption that players have “hot hands” and have more chances for another successful shot after a series of hits.
The paper claimed that people misinterpreted randomness and made incorrect conclusions as a result, like in a coin toss, where people believe that the probability of the coin coming up heads or tails increases after the coin came up heads or tails the previous toss, when that is not the case. In their study, supported by numerous experiments and statistical data, GVT concluded that the sense of being “hot” cannot predict or guarantee future hits or misses.
Psychology behind hot-hand fallacy
The hot-hand fallacy may happen for two reasons:
Pattern seeking: People like to see patterns in things, even when there is no pattern. If you have ever seen a cloud and thought it looked like something, then you will know what that means.
Insufficient sample size: Often, when people see that something has taken place a small number of times, then they think that that is a sufficient sample size to judge from.
Hot-hand fallacy vs Gambler’s fallacy
Hot-hand fallacy is the binary opposite of the gambling fallacy, which is the belief that the probability of something happening becomes lower as the process is repeated. In trading, this bias can cause traders to close a position prematurely because they believe that an instrument’s price is unlikely to continue its trend, and that the chances of it rising (or falling, in case of a short position) further decrease with time.
Hot-hand fallacy’s effect in trading
Excessive risk-taking: The hot-hand fallacy can lead to overconfidence, which can lead a trader to take more risk than they are otherwise comfortable with.
Ignore signs of reversal: Under the influence of the hot-hand fallacy traders may keep a winning position open for too long, even if there are clear signs that a trend reversal is likely to occur.
Irrational decisions: Traders who succumb to the hot-hand fallacy may open new positions impulsively, making irrational decisions in their trades.
Confirmation bias: The hot-hand can give rise to confirmation bias, where traders deliberately seek out information that reinforces their beliefs. It may lead a trader to look for evidence that their next trade will be successful and ignore the bigger picture.
Hot-hand fallacy examples
Let’s take a look at an example of hot-hand fallacy in contracts for difference (CFDs) trading.
Imagine that a trader has been closing profitable CFD positions on a particular market for several weeks, and is starting to feel like they have a "hot hand." They may begin taking more risk, assuming that their winning streak will continue, and end up making a trade that results in a significant loss.
On the other hand, suppose a trader sees that a particular market has been performing well recently, and assumes that it will continue to do so, despite there being evidence that suggests a price correction may occur soon. They may take out a large CFD position for the asset’s value to rise, but a price decline takes place, causing them to lose money.
How to avoid the hot-hand fallacy bias
The hot-hand fallacy exists, but there are tactics that may help traders avoid it.
Acknowledging it exists: Knowing that the hot-hand fallacy is something that can affect traders means that a trader can analyse whether or not the hot-hand fallacy might apply in their case.
Conducting thorough research: Conducting thorough analysis of market fundamentals and technicals, and using a variety of sources, may help traders base their decisions on facts rather than emotions.
Designing a trading strategy: Having a trading strategy with clear entry and exit points may help traders to avoid impulsive decision making.
Keeping a trading diary: Having a record of your trading decisions including the thinking process behind them may help guard against the hot-hand fallacy. This is because having the facts and the reasoning laid out can identify whether hot-hand fallacy has been affecting your decisions.
Seeking feedback: Sometimes an external perspective may help you realise cognitive biases that may have influenced your deduction. Asking fellow traders therefore may be beneficial in identifying and preventing hot-hand fallacy.
Conclusion
The hot-hand fallacy is a cognitive bias that leads traders to believe that a successful streak is likely to continue. The term “hot-hand” is borrowed from the US basketball slang and refers to the belief that a player who successfully scores will have “hot hands” and will be able to score again with his next shot.
The hot-hand fallacy originated in 1985, when behavioural scientists Thomas Gilovich, Robert Vallone and Amos Tversky. It happens because people tend to seek patterns and base their judgements on insufficient sample size.
In trading hot-hand fallacy may lead to excessive risk-taking, ignoring signs of trend reversals, impulsive trading and confirmation bias. To avoid hot-hand fallacy traders may consider recognising the bias, conducting thorough research, keeping a trading diary and seeking out feedback from fellow traders.
FAQs
What is the hot-hand fallacy in simple terms?
In simple terms, the hot-hand fallacy in trading is a cognitive bias that leads traders to believe that a successful streak will continue. A trader will often try to follow up a winning position with another in hope that it will also be a success, even if there are signs that it will be otherwise.
What is an example of the hot-hand fallacy?
Imagine that a trader has been closing profitable CFD positions on a particular market for several weeks, and is starting to feel like they have a "hot hand." They may begin taking more risk, assuming that their winning streak will continue, and end up making a trade that results in a significant loss.
