Wednesday, May 21, 2014

How Gamblers Get Hot (the 'hot hand' is real)

Recognizing and then managing a trader's hot streak is one of the more challenging things you can do in finance especially when the trader can't articulate what's going on, whether in credit derivatives or octopods who pick World Cup winners.
From the New Yorker:
When your betting “hobby” goes degenerate and those Sunday football bets spill over into Monday Night Football bets and then Wednesday college-basketball bets and then lunch-break bets on the five horse in the third race at the Aqueduct, there’s one mantra that can bring you a measure of comfort: every gambling theory is wrong, and, because gamblers all have theories, every gambler will eventually be as broke as you. The sense of community among the people who fall asleep at poker tables or ride the bus to Foxwoods or crowd around off-track betting screens comes, in part, from a collective sense of bewilderment. How could all of us be wrong all the time?

Last month, researchers at University College, London, released a study that seems to confirm the existence of one of gambling’s most ubiquitous and destructive theories: the “hot hand.” Loosely defined, the hot hand, better known as the hot-hand fallacy, is the idea that winning begets more winning. Suppose you’re playing blackjack and you hit sixteen against the dealer’s ten and then pull a five. This swing of luck prompts you, on your next hand, to double down on nine against a dealer seven. When the dealer slides you an ace, for a total of twenty, you win, and you certainly aren’t going to stop betting now. So, in the next hand, you split sevens against a dealer eight (a terrible decision) because you’ve just won two hands in a row and how could you possibly lose a third? That’s the hot hand in all its ruinous glory.

Juemin Xu and Nigel Harvey, the study’s authors, took a sampling of 569,915 bets taken on an online sports-gambling site and tracked how previous wins and losses affected the probability of wins in the future. Over all, the winning percentage of the bets was somewhere around forty eight per cent. Xu and Harvey isolated the winners and tracked how they fared in their subsequent bets. In bet two, winners won at a rate of forty-nine per cent. From there, the numbers go haywire. A player who had won two bets in a row won his third bet at a rate of fifty-seven per cent. His fourth bet won sixty-seven percent of the time, his fifth bet seventy-two. The best gamblers in Las Vegas expect to win fifty-five per cent of their bets every year. Seventy-two per cent verges on omniscience. The hot hand, it appears, is real.

Losers, unsurprisingly, continued to lose. Of the 190,359 bettors who lost their initial bet, fifty-three per cent lost their next, and those who had enough money left for a third round lost sixty per cent of the time. When unfortunate bettors got to five straight losses, their chance of winning dropped to twenty-three per cent. The losing streaks should be familiar to problem gamblers and can be explained by another well-worn theory called the gambler’s fallacy. If you’ve ever called heads on a coin flip, seen the coin land tails up, and then called heads again because “heads is due,” you’ve been caught up in the gambler’s fallacy....MORE 
Baseball and Investing: "The ‘hot hand’ might be real after all"
"Luck vs. skill: What Bill Gross and Bill Miller have in common"