Position Sizing: Avoiding the Gambler’s Fallacy and Recovery Trauma in Trading

Gambler’s fallacy

Check out this chart- 

This chart of Nifty shows it hitting the impressive milestone of 10,000 on July 25th, 2017. As a trader, how would you approach this?

Nifty is at an all-time high – 10K

Some market players might take advantage of this psychological border and secure their gains.

An all-time high indicates there are no hurdle points.

Nifty has been steadily increasing in recent weeks.

It’s possible that Nifty will hold its current level.

Wouldn’t it be helpful to make a small adjustment of 2-3% before the rally resumes?

Let us suppose that these points hold up. This implies that a short position would be appropriate or the purchase of puts. Your approach could be as elementary as this, or even more complicated such as examining time series data and modelling it using complex statistical or machine learning models.

No matter what you do, there is no assurance of success in the markets. No strategy can signal what will happen in advance. This means we are dealing with a largely unpredictable situation. Your chances may be improved by how accurate your analysis is, but ultimately, unpredictability rules and markets remain capricious.

Imagine you’ve conducted a top-of-the-line analysis and placed your bet on Nifty, only to have your stop loss activated. You persist, but the same disappointing result appears time and time again – four trades in a row lost.

You have faith in your analysis and the markets are undoubtedly going to turn around. You have funds available to make further investments, and your risk-taking attitude remains. What do you do then?

Would you stop trading?

Would you take the same chance with your finances?

After incurring six losses in a row, would you up your bet to regain the money you’ve lost and make a profit on the seventh trade?

What is your course of action?

Having experienced this myself and having talked to numerous traders, I can tell you that a majority of them would go with the third choice. Why is that?

Traders have a tendency to think that long stretches of misfortune will finish when they make the following move. In this particular situation, the dealer has endured 6 successive misfortunes, yet at this moment, their conviction that the 7th trade will be a success is very solid. This is known as the ‘Gambler’s Fallacy’.

No matter what your previous trades have been, the chances of making a profit on the 7th trade remain the same. It doesn’t matter if you’ve lost consecutive times or won them all – your odds of success on the next bet are unchanged.

Traders are prone to ‘Gambler’s Fallacy’ which involves placing bets without fully grasping the odds. Unsurprisingly, this has a detrimental effect on position sizing strategies and usually results in a depleted trading account.

Say you are blessed to have a streak of 6 or even 10 winners. Regardless of what you stake, the result is in your favour. When it comes to the 11th one, what would you do?

Would you stop trading if you had enough money?

Would you be willing to take the same risk?

Are you willing to raise the amount?

Will you adopt a conservative stance, safeguard your profits, and thereby decrease your bet amount?

It is likely that the 4th option is the best course of action for you, as it will ensure your profits remain stable and you can continue to capitalise on your recent successes in trading.

This is also ‘gamblers fallacy.’  

By allowing the results of the previous 10 trades to heavily influence your decision, you are essentially decreasing the size of your position for the 11th trade. However, in reality, this new trade carries the same probability of either winning or losing as the previous 10 trades.

It is likely that this accounts for why some traders, despite entering into a cycle of profitable trading, still make very little money.

The best way to counter ‘Gambler’s Fallacy’ is with properly-employed position sizing.

– Recovery trauma

In the trading arena, capital is the main ingredient. Without sufficient funds to invest, it’s highly unlikely one will make a return on their investment. As such, it’s essential to safeguard both profits and capital.

Risking too much capital on any one trade could lead to a near total loss of capital, leaving you with very little money and every trade increasing in risk. Reversing this downward spiral can be an almost impossible feat.

This table can assist you in understanding this. Assuming you are beginning with a trading capital of Rs.100,000/-, let us understand the results –

If you were to lose 5% of your capital, or Rs. 5000, your new starting figure would be Rs. 95,000. It would then require a return of 5.3%, an extra 0.3%, in order to make up the initial shortfall.

Rather than incurring a 5% loss, assuming you lost 10%, then your capital would be reduced to 90,000. To recuperate the 10,000 or 10% of your original capital in this situation, you must make an 11.1% gain. As the loss increases, so does the effort to return to your starting capital—for instance if it’s raised to 60%, the figure then rises to 150%.

Traders with smaller account sizes are unfortunately affected by ‘recovery trauma’. For example, if you start with Rs.50,000/-, chances are you’ve heard the stories of how Rakesh Jhunjhunwala grew his fortune from 10,000 to 15K Crores. It’s understandable that you would want to try and replicate a portion of that success. Achieving 20% return, i.e., growing Rs.50,000/- to Rs.60,000/- in 1 year is a good result but it’s natural that it wouldn’t appear appealing to an active trader.

What would you do? You usually go for larger ventures with the aim of getting greater rewards, yet if the investment doesn’t pay off, you can fall into the ‘recovery trauma’ ordeal.

It’s important to keep your bets in check when trading with a small capital. By doing so, you give yourself a much better chance of profiting from the markets over time – the only way to stay in-game for the long haul. Keeping an eye on position sizing ensures there is sufficient capital available at all times and will help you experience market stability and reap its rewards.