Loss Aversion in Option Pricing
Posted: 10 Jan 2010
Date Written: December 28, 2009
Abstract
This piece uses a computer program to report a real-time empirical finding that loss aversion (Kahneman and Tversky 1979, 2000, Ye 2005) exists in option pricing (Black and Scholes 1997; Hull 2009). This occurs on strike-on-spot price which is the closest strike price to the spot price of the underlying asset. For call options, traders feel a gain when a strike price goes up, whereas a loss when the strike price goes down. A Web-based computer program collects real-time empirical data from a random sample (32 tickers) with call premium changes for loss and gain conditions. Real-time t-tests (see the bottom of a table generated by the computer program) are performed to repeatedly demonstrate the significant difference between the loss over gain ratios vs. 1. The data suggest that traders' mental response to asset price drops is significantly larger than that of the same price increases. This real-time empirical finding repeatedly demonstrates loss aversion in option pricing.
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