The “Hot Hand” effect, originating from basketball terminology, refers to a situation where a player consistently scores many points. Let’s examine this phenomenon in the context of trading and how it affects investors.
Greed in trading is a familiar topic. One manifestation of greed is that after a winning streak, traders tend to enter the next trade with a larger-than-usual position, believing that this trade will also be a winner.
Many investors have faced this situation, and the end of a long winning streak is often a bitter failure. In such cases, it may not necessarily be greed, but rather investors falling prey to the Hot Hand effect.
From basketball…
For those who follow the NBA basketball league, it’s known that in the world of basketball, tall players compete vigorously for a ball, continuously scoring at a much faster pace than in soccer. Each team usually has a scoring powerhouse, and when this player has the ball, the team gains confidence. If the scoring powerhouse achieves a consecutive scoring streak, people automatically assume that their next shot will not miss. This is the Hot Hand effect in basketball.
…To trading
Sometimes, traders also experience winning streaks, and there’s an assumption that the next trade will be a winner, similar to the scoring powerhouse in basketball. The difference between traders and basketball players regarding the Hot Hand effect is that when a basketball player ends a winning streak, they only miss the chance to score, while traders face the risk of heavy losses due to an inclination to increase position sizes, overly confident in the next trade.
The Hot Hand is a psychological effect, equally dangerous as FOMO (Fear of Missing Out), and sometimes even more so.
FOMO is simply the fear of missing an opportunity, and with good risk management skills, it may not cause much harm. However, with the Hot Hand, the psychological effect paints a rosy picture of the next trade being a winner, causing traders to overlook risk management and confidently place orders with larger-than-normal sizes.
Facing the “hot hand” effect in trading requires vigilance and effective risk management. Investors need to recognize that each trade is independent, and relying on past success to evaluate the potential success of the next trade is not wise. Maintaining objectivity and adhering to risk management techniques are key to avoiding falling into the Hot Hand effect and protecting one’s investment capital.
By. Pham Thanh Bien
>> Learn Risk management strategies here
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