Clustering Illusion is the tendency to see non-random sequences in a string of random data. It is especially dangerous for traders, because perceiving a non-random pattern in a random string of wins or losses may lead us to increase leverage or trade sizes, which could eventually lead to large losses or the wipe-out of an account.

X being heads, O being tails, the string XXXOXOOOXO appears non-random to many of us at first sight, as it has two large clusters of OOO and XXX, but in fact the total number of Xs Os are equal, and the clusterings could just be the small part of a larger, more evenly-distributed sample. Many traders mistake strings of random groupings for a non-random distribution of results, and decide on the value of a trading strategy on this basis. However, we need quite a bit more than visual identification to prove to us the non-random character of a data stream.

The gambler's fallacy is partly a result of the clustering illusion. Due to the clustering illusion, the gambler sees non-random streaks in a random pattern, and concludes on that basis that a long streak of tails or heads implies a higher likelihood of the streak being broken on the next coint toss. Of course, a streak of XXXXXX is perfectly possible in a long streak of coint tosses, but if we were to hit six heads in six tosses in a row, our friends would all clap their hands and congratulate us on our grand streak of luck. In this context, luck implies that the coin tosser somehow has caused the results to become dependent on each other, that he has the "flair", that his string of incomes makes it likelier that he will make even more winning bets. However, we have already stated the above pattern is perfectly possible in a random string. Thus the coin tosser, and his friends are all wrong about the luck of the coins or their owner.

When evaluating trading results, the clustering illusion is the worst foe of a trader. The appearance of strings of wins or losses by no means suggests that the strategy we use is providing us with superior returns. Similarly, such strings should never constitute enough reason, by themselves, for increased leverage, or larger trade sizes.

How do we avoid the clustering illusion?

From the above discussion, it is clear that the clustering illusion is a dangerous phenomenon, due to its tendency to lead to false signals and unjustified confidence. It is especially detrimental to the success of a trading strategy, because the success or failure of a technical method is only measured in terms of its wins or losses.

There are two ways of avoiding the problems associated with the clustering illusion. One is to use mathematical tools, such as the z-score, to gauge if the concatenation tendency of our profits and losses constitute a random pattern or not. The other method is to trade less, and use long term methods in order to reduce the total number of "coin tosses" we do, and to altogether reduce the role of volatility and short term swings on our portfolio.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.