Psychology, Stock/FX Trading, and Option Prices

Abstract

The financial crisis of 2008 had many putative causes. Psychology was an important driver for human decisions underlying these causes. However, quantitative financial models have no “knobs” to dial psychology parameters, and so arguably cannot possibly cope with financial crises. We have no illusions of the difficulty of including psychology in financial modeling. Here we take a first step by considering how a particular aspect of psychology can influence an underlying security and subsequent option prices, in a quantitative model. The underlying security can be a stock or an FX rate. There are three steps. First we investigate how psychological regret and fear impact trading selling behavior. Second we use results from the first step to link this changed trading behavior with induced changes in underlying security prices. Third, we consider changes in option prices due to these induced underlying security price changes. The results can be expressed either as a modified effective dividend for stock options, a modified effective interest rate for FX options, or an unusual change in implied volatility. Options analysis for some USDCAD FX European options with implied parameters indicates this approach has some empirical relevance. The contribution of this paper is thus threefold: 1. The paper breaks ground by emphasizing the desirability of incorporating interdisciplinary explicit interaction between behavioral finance and securities modeling, 2. The paper provides a definite model with a quantitative mechanism of how a particular psychological behavior can influence the prices of some securities, and 3. The paper shows that this model can facilitate the description of some illustrative option data.