The Gambler’s Fallacy: A Pitfall in Trading

All financial markets have a component of unpredictability to them. They technically have two paths to follow, up or down. Because of this traders often struggle with various cognitive biases that can impact their decision-making process. One of the more pronounced cognitive biases, the Gambler’s Fallacy, can lead traders down a dangerous path of making illogical decisions.

Trading anything, be it stock, options, futures, currency, requires rational decision-making if you expect any inkling of success. Most traders can perform a logical analysis on technical charts but human psychology often leads them to make irrational choices based on cognitive biases against their own analysis. The Gambler’s Fallacy is a classic example of a bias that plagues traders.

Unraveling the Gambler’s Fallacy

The Gambler’s Fallacy, also known as the Monte Carlo Fallacy, gets its name from the world of gambling. It’s the belief that past outcomes in a random sequence will affect future outcomes. In essence, it’s the assumption that if a specific event occurs more frequently than normal, it’s less likely to happen in the future and vice versa. For example, in a coin flipping game, if heads come up several times in a row, a person under the influence of the Gambler’s Fallacy may believe that tails is “due” to come up soon.

Regardless of past outcomes, there is always a 50/50 chance that the coin will land on heads or tails.

The Gambler’s Fallacy in Trading

How does this cognitive bias translate into the world of trading? Traders, looking to make sense of market movements, often fall into the trap of believing that past price movements will influence future prices. For instance, if a stock has been rallying for several days in a row, traders caught in the Gambler’s Fallacy might start believing that it’s “due” for a decline. This can lead to getting into short positions too early or prematurely closing long positions. Conversely, if a trader sees a series of red candles on a price chart, they might assume a reversal is imminent, which may not be the case at all.

Adding to this complexity, technical indicators like the Relative Strength Index (RSI) or Bollinger Bands can inadvertently reinforce the Gambler’s Fallacy. When traders see an oscillator like the RSI is overbought (usually above 70) or in oversold (typically below 30), they might interpret that as signals that a price reversal is imminent. This is a manifestation of the Gambler’s Fallacy. In reality, overbought or oversold conditions do not guarantee immediate reversals, as market conditions can remain irrational for extended periods.

Traders should use these indicators as supporting evidence, but never the primary component of a trading thesis. Trend analysis, price action analysis, and intermarket relationships will always be far more important, and actually help you avoid falling into the Gambler’s Fallacy.

Avoiding the Pitfall

To overcome the Gambler’s Fallacy, traders must recognize that financial markets are not influenced by past price movements but rather by the ongoing narrative of traders and investors participating in the world’s largest auction.

A reasonable question then might be: Why bother with technical  analysis? The answer is that horizontal levels represent where positions are held from (inflection points), and understanding human psychology (the HOW price arrived at a level) represents the strength of any one side of the auction. When we know strength and location, we have some idea of how to manage our risk.

Some strategies or thoughts to help beat the cognitive bias can be as follow:

Embrace randomness: Remember that market movements are inherently random. Each trade is independent, and past outcomes do not influence future ones. A new day always represents an opportunity for the market to move in either direction. Up or down.

Set a trading plan: Develop a well-defined trading plan with specific entry and exit criteria. Stick to your plan, and avoid making impulsive decisions based on short-term deviations. A plan takes the emotional guesswork out of entering positions.

Risk management: Implement proper risk management techniques, including setting stop-loss orders and not risking more than you can afford to lose. Position sizing allows you to take trades confidently without fear of losing more than you “budgeted” for.

Conclusion

The Gambler’s Fallacy is a cognitive bias that can significantly impact trading decisions. Understanding that market movements are not influenced by past price outcomes but by various economic factors is vital. To thrive as a trader, embracing randomness, setting a trading plan, using technical and fundamental analysis, practicing effective risk management, and seeking advice are critical steps to avoid falling into this cognitive pitfall. In the dynamic world of trading, success depends on making rational, informed decisions rather than relying on fallacies.