How To Use Behavioral Finance To Make Money?

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Includes: AIG
by: Saidrasul Nasretdinov

Summary

The topic of this article is to use some of the behavioral biases of investors to generate alpha.

In the first section of this article, we’ll discuss how to take advantage of “loss aversion”.

In the first section of this article, we’ll discuss how to take advantage of “temporal discounting”.

Haven't we heard enough about how typical investor is not fully rational and does not really epitomize "economic man"?! In their 1979 paper published in Econometrica, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i.e., losses bite about 2.25 times more than equivalent gains. But, understanding the theory, various biases, and why those might exist and persist is only useful if you have an intellectual curiosity about the topic of behavioral finance. What about using this knowledge to generate alpha over the long-term?

Leverage "loss aversion" to generate alpha

Fortunately, the desire to come up with practical applications for investors has sparked quite a bit of research. Namely, in the research conducted by Goldman Sachs team, they found that 5% OTM calls historically exhibited 69% win rate, while 5% OTM short puts 92% win rate. What's the takeaway:

  1. Long call and short put positions offer a pretty good win rates
  2. Option traders clearly exhibit loss aversion, which is clear from higher win rate offered by short puts vs. long calls. Fear is more potent emotion than greed.

Of course, win rate does not equate to alpha, as you might be losing a lot when trade is in a loss position and make a little during "win" cases. Additionally, one can argue that option win rates mentioned above correspond to typical market gyrations; i.e. market tends to be in an up-cycle longer than in a down-cycle. The Bulls climb up the stairs and the Bears fall out the window.

You would think that market would price options in a way that would ensure no arbitrage. This might be the case. Others might argue that going long calls is similar to leveraged stock investing, i.e. multiple exposures to beta. So, by going long you have good win rate and likely handsome payoff thanks to levered beta exposure. Going short, on another hand, is similar to selling an insurance policy. This works most of the time (seems around 92% of a time), but when it doesn't it can wipe your entire position out. Remember AIG (NYSE:AIG) in 2008 (that was short CDS position… but short put options have very similar payoff characteristics)?

In other words, I'm not recommending going long calls and shorting puts. You would think that market should get to no-arbitrage pricing at some point. Additionally, this strategy would not be suitable for many. However, if you know how to manage "wipe-out" risk, you might be willing to leverage others' loss aversion to your advantage.

An example of how to use "win" rate in practice (remember, "win" rate is not equivalent to rate of return)

Thanks to comments from the readers of this article (particularly, thanks to Silent Trader), I realized that it is not sufficient to limit the discussion to "win" rate. Instead, I should highlight how "win" rates could be leveraged by traders to generate profit. At the end of the day, you will not be a winner if you win $1 in 69% of a time and lose $10 in 31% of a time. Expected outcome of such bet is negative. So, how one can fix this issue and still take advantage of "win" rates. traders can utilize the knowledge about "win" rates to devise a strategy involving loss-limit rules that would allow them to take advantage most (if not all) of the upside while limiting downsize to a particular level.

Given that "win" rate is in their favor, they should be able to generate handsome returns through limiting downside. Why do I think this should work? Because Martingale System works even for roulette (where "win" rate is lower than 50%) and in this case, one needs to figure out how to equalize payoff and loss amounts in case of "win" and "lose".

So, how one can fix this issue and still take advantage of "win" rates. You just need to find a way to have dollar impact of "win" and dollar impact of "loss" scenarios equal to each other. One needs to figure out how to equalize payoff and loss amounts in case of "win" and "lose".

For instance, if investor made 40% return when long call position work out ("win"), she might set 40% drawdown limit when she rolls the position. Loss-limit rule is likely to increase her chance of "loss", i.e. she might be stopped over more often. However, you might run historical backtest to find a point where "win" rate would still be higher than 50%. Even then there are cases when market liquidity dries up and one might not have actual quotes. In this case, neither stop losses or similar tools would help.

Furthermore, one can argue that market's propensity for over-reacting to fear is already priced into the pricing of put options. Therefore, observation of "win" rates could be nothing but a reflection of asymmetry of payoffs.

Leverage "temporal discounting" to generate alpha

Temporal discounting is the tendency of people to discount rewards as they approach a temporal horizon. To put it another way, it is a tendency to give greater value to rewards as they move away from their temporal horizons and towards the "now". For instance, a nicotine deprived smoker may highly value a cigarette available any time in the next 6 hours but assign little or no value to a cigarette available in 6 months.

Applying temporal discounting to option pricing, one might realize that supply-demand dynamics might lead to relatively cheap, longer dated maturities. One might argue that people would not be trapped in temporal discounting when it comes to option pricing. Don't we all use IV's calculated using Black-Scholes? Yes, we do. However, don't forget that our models assume that volatility increases with the square root of time and that IV levels are driven by actual demand (and supply) dynamics.

Trending markets and the fact that momentum factor worked its magic, one can clearly see that volatility does not increase with the square root of time in practice. Hence, volatility is typically underpriced for longer dated options. This makes LEAPs a somewhat cheap instrument over the long-term (you might be interested in Jamie Mai's points covered on this topic). Of course, there will be times when IV jumps due to market fear, however over the long term, human nature (temporal discounting) is likely to keep the price of LEAPs cheaper than they should be.

Conclusion

Investors might be able to take advantage of market's "loss aversion" by rolling long call and short put positions. However, this approach comes at the expense of "wipe-out" risk. Keep the AIG 2008 experience in mind!

Temporal discounting is another behavioral bias that is unlikely to change. Want to take advantage of it? Consider buying longer dated options (LEAPs) instead of shorter-term options for your option rolling strategy.

Disclosure: I am/we are long SPY, IWM, EEM, QQQ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I'm long call LEAPs on SPY, IWM, EEM, QQQ