What is the gambler's fallacy in trading?
In one line: The gambler's fallacy is believing that after a run of losses a win is "due," or the reverse, when each outcome doesn't depend on the last one.
The idea
Flip a fair coin. It lands tails 5 times in a row. What's the chance of heads next?
Still 50%. The coin has no memory. Feeling that heads is "due" is the gambler's fallacy.
A simple example with numbers
Say your trades win about 50% of the time. Each trade is close to its own coin flip.
- The chance of losing 1 specific trade: 1 in 2.
- The chance of losing 5 in a row: 0.5 × 0.5 × 0.5 × 0.5 × 0.5 = about 3%, or 1 in 32.
1 in 32 sounds rare. But over 200 trades there are many stretches of 5. So a 5-loss run is quite likely to show up at some point. The losing streak calculator shows how long a streak to expect for your Win rate.
After those 5 losses, the next trade is still about 50/50. Nothing is owed.
Why it matters
The fallacy leads to the riskiest move in trading: bigger size after losses.
"I've lost 4 in a row, the next one has to win, so I'll double up." If it loses too, the damage is far bigger than planned. That's how a normal streak becomes a deep Drawdown. See risk of ruin.
It also works in reverse: "I've won 5 in a row, I'm due for a loss," so you skip a valid setup.
A common mistake
Changing size based on the last few results. Keep risk per trade the same, win or lose. Let the streak run its course. More in how to handle a losing streak.
A daily stop, like 2 losses and done, ends the day before "it's due" thinking can start. See revenge trading.
Questions
What is an example of the gambler's fallacy in trading?
Doubling your size after 4 losses because "a win is due." Each trade's chance doesn't change because of the ones before.
Are trades really independent like coin flips?
Close enough for sizing. Markets can change mood over time, but a past loss doesn't make the next trade more likely to win.
How is this different from recency bias?
Recency bias expects a streak to continue. The gambler's fallacy expects it to reverse. Both read too much into a few trades.
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