Losers and Prospectors in Short-Term Options

Abstract

We investigate short-term index options for behavioral biases implied in prospect theory (PT). Intraday price and transactions patterns generally support the theory. Losers are seen to be relatively risk seeking and winners to be risk averse, with the former effect appearing stronger. On aggregate, losers (winners) overprice (underprice) their contracts and overweight (underweight) the probability of winning. There is heterogeneity across samples when winners and losers are defined by their current and prior performance, with the latter measure providing weaker evidence of distortions. However, both samples indicate that the volatility smirk observed in equity options is dampened by PT biases, and document correspondence between the disposition effect and PT. For losing traders, the behavioral biases are time sensitive. Losers hold out, transacting later in the day and closer to expiration than their baseline. Further, the probability-overweighting among losers is an inverse function of expiration time. The observed time-sensitivity is consistent with field experiments documenting the increased attractiveness of long-shots as a series of bets that draw to a close. Also notable, is that the betting-time effect is absent among winners.