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Gambler’s Fallacy: What Roulette Can Teach us about Trading

Last updated 5/18/2012 12:31 PM EST (GMT -5) 3 Comments

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Matthew Weller

Technical Analyst, GFT

Midway through the day of August 18, 1913 at the Monte Carlo Casino in Monaco, gamblers were witnessing something very unlikely: the roulette wheel had landed on a black number a dozen straight times.  

As anyone who’s ever watched or played roulette can imagine, the gamblers rushed to place bets on red. They were betting that the unreal streak of blacks would come to end, some doubling or tripling their bets as the wheel refused to yield a red roll. Unfortunately, this was the wrong strategy on that day: By the end of the streak, the ball had landed on black an incredible 26 consecutive times, resulting in tremendous losses for the gamblers and one of the casino’s most profitable days ever (Huff & Geis, 1959).

The gamblers suffered (and the casino benefited) from an inherent cognitive bias called Gambler’s Fallacy . Gambler’s Fallacy is the belief that a departure from a long-term average will be corrected in the near-term. Obviously, black and red numbers on the roulette wheel are equally likely to appear on each spin; if we assume no green “0” or “00” slots in the wheel (a simplification for the sake of the article), the probability of each appearing is 50%, or a coin flip. From any given coin flip, probability tells us that we would expect heads or tails to occur the next 26 consecutive times is an astronomically small .0000015% of the time or about once every 67,100,000 times (given the presence of green numbers on the roulette wheel, the actual probability was even lower).

However, what the gamblers failed to realize is that the probability of each incremental roll landing on black is still about 50%. In other words, even after 26 straight black rolls, the probability of black coming up on the 27 ^th roll was still roughly a coin flip. From a logical perspective, consider that the dealer was not changing the way he was rolling the ball, or even more preposterously, that the inanimate ball had decided to stop landing on black numbers. Nonetheless, casinos continue to use this fallacy to their advantage, with every modern roulette wheel equipped with a sign showing the past 20 spins, an addition that makes it incredibly easy for gamblers to exercise their natural temptation to bet against streaks.

Gambler's Fallacy in Trading

The Gambler’s Fallacy has obvious implications for trading. As anyone who has traded for any length of time has realized, there are streaks of winning and losing trades. After losing streaks, many traders are tempted to increase their position size, rationalizing that they’re “due for a winning trade.”  Unfortunately, as the traders in the Monte Carlo casino discovered 99 years ago, the odds of any given trade being successful would be better estimated by the long-term success rate of similar trades in the past. Conversely, there is no logical reason to decrease position size after a streak of winning trades, assuming traders continue to follow their trading plan.

Implicit in the last statement is the expectation that traders actually have a trading plan and keep a detailed record of past trades (for more on trading plans, see my colleague Brad Gareiss’ articles “Creating a Trading Plan” and “Following the Plan” ). Arming yourself with this data will go a long way toward helping you avoid falling victim to Gambler’s Fallacy. By examining a detailed track record of past trades, traders can put a recent string of winning or losing trades into perspective. 

In addition, traders should have a consistent risk management and position-sizing strategy. This means that the same, relatively small, amount of risk is set for each trade. For some traders this might be relative to a set number of pips, while others may prefer to adjust their position size so each trade represents a given percentage of their overall account. For instance, many successful  traders put only 1-3% of their total account equity at risk on each given trade. Regardless of the strategy you use, it’s important to be consistent despite winning or losing streaks.

The final way to minimize the impact of the Gambler’s fallacy on your own trading is the same for many trading psychology issues: just be aware of it! Think back to this article the next time you’re tempted to adjust your position size or trading strategy after a streak of trades, and remember, the market does not care what happened over your last 5, 50, or 500 trades.

Hopefully, after reading this article, you will be able to maintain a better perspective during inevitable streaks of winning and losing trades, and potentially avoid a common pitfall at the casino!

Huff, D & Geis, I. (1959). How to take a chance. W. W. Norton & Co, Inc.

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Comments (3)

Jack_Mckee_13

February 05, 2012 at 10:09 PM ET

Great article - thanks for the reminder. Trading is all about maintaining discipline once you have a strategy.

MWeller

February 06, 2012 at 08:44 AM ET

Thanks Jack - couldn't agree more.

Stay tuned for the next article this Friday!

flavius

May 18, 2012 at 01:48 PM ET

nice job matt,very imp to keep in mind that trading is moore like a job not a game,so don t mess around when you work :)

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