Market Instability, Investor Sentiment, and Probability Judgment Error in Index Option Prices

Abstract

In a natural experiment with index option prices, we study how probability judgment error, and probabilistic risk attitudes, characterize investors’ sentiment about the ranking of index option attractiveness, the weight they place on each rank, and their ability to discriminate between prices. We introduce a novel behavioral process that (1) characterizes investor sentiment about tail events in index option prices over time and probability ranks, (2) provides early warning signals of market instability, and (3) crash probability estimates from a closed form expression for the time varying transition probability that a seemingly stable market state will become unstable and crash.