The flow and the hot-hand fallacy

When I played basketball we often made end-of-game decisions based on who had the “hot hand.”  Meaning, we would give the ball for the final shot to the player who had been shooting the best for the night.  For many years this was debated in academic circles and it was generally considered a fallacy called, indeed the “hot-hand fallacy“.

More recent studies seem to show that there is some evidence that someone who had made a shot before in the game is more likely to make one again, compared to someone who missed an earlier shot.   Regardless of what researchers says (it’s all interesting…. but seriously, you need to spend your Ph.D. on this?!)… here is my personal take, having experienced the “hot-hand” or the “flow“, and it applies perfectly to sports and trading: 

  • there are times when something special happens in our brain that makes things slowdown and become super-clear,
    • brain is in total control of emotions
    • the “feel” for the game is immaculate
    • decisions are easy to make
    • decisions are quick
    • everyone else is in slow-motion
      • I once came off the bench to score 10 points in less than 2 minutes, stealing the ball once, gave one assist, one dunk and two 3-pointers. Our team was down by 8-10 points or so, but we ended up winning.  It was 25 years ago.  It was so magical, I still remember it!
  • I believe the difference between the hot-hand being a fallacy or being a reality is the skill level of the player:
    • In a total game of luck, such as a roulette or a half-court shot by my grandma, I think it’s a fallacy
    • In a game of skill, the hot-hand exists and it’s worth exploiting it
  • The most important skill to have when you are in the “flow” is to recognize when the mojo is gone.  
    • In basketball, we shoot too much, well past the “flow”, but luckily the coach can take us out.
    • In trading [AND THIS IS THE KEY POINT ON THE ENTIRE POST] you need to have a plan in advance to control your behavior when everything is going your way.  Here is an example:
      • Don’t make more than 3 trades in one day
      • If you are going to increase the size of your position, do it by pyramiding into it (i.e., if you start with 3 contracts, don’t add 3 or 5 more, but add 2 or less) and putting trailing stops.
        • Alternatively, take profits are pre-set points, have a target
      • Don’t overtrade in too many market as it is easy to loose focus
      • Keep your routines the same.
      • Get sleep.

Know that a drawdown is just around the corner.  Don’t let it discourage you.  Markets are never unidirectional.  The more profits you can capture as your NLV rises, the stronger you will be when the market flows back against you.  Remember that not trading is one of the best strategies you’ve got.

BONUS: if you have never seen what a hot-hand looks like… check out this out!

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