Behavioral Biases and Retail Options Trading

Behavioral finance is important, but it's not often discussed in quantitative trading. In this issue, I explore some aspects of behavioral finance.

In this issue:

• Latest Posts

• Why Do Investors Lose Money?

  • Findings

• Retail Options Traders’ Behavior

  • Findings

• Closing Thoughts

• Educational Video

  • Behavioral Finance and the Role of Psychology

• Volatility Weekly Recap

• Around the Quantosphere

Latest Posts

• The Rise of 0DTE Options: Cause for Concern or Business as Usual? (11 min)

• How Machine Learning Enhances Market Volatility Forecasting Accuracy (12 min)

• Predicting Corrections and Economic Slowdowns (11 min)

• Rethinking Leveraged ETFs and Their Options (12 min)

• Using Skewness and Kurtosis to Enhance Trading and Risk Management (10 min)

Why Do Investors Lose Money?

Behavioral finance is the study of how financial behavior affects economic decisions and market outcomes, and how those decisions and outcomes are affected by psychological, social, and cultural factors.

Behavioral finance research has shown that people do not always make rational decisions when it comes to money. Factors such as emotion, social pressure, and cognitive biases can all lead to suboptimal decisions. Reference [1] lists mistakes made by investors:

Findings

• Investors often fail to diversify adequately, exposing themselves to unnecessary idiosyncratic risk, which results in lower overall returns that could be avoided with simple diversification strategies.

• Many investors underperform the mutual funds they invest in due to poor timing decisions, such as buying high and selling low, which diminishes the benefits of professional fund management.

• The disposition effect leads investors to sell winning investments too early while holding onto losing ones for too long, negatively impacting portfolio performance over time.

• Investors who pay insufficient attention to markets or their portfolios tend to earn lower returns compared to more engaged and informed peers.

• Investment behavior is often reactive; individuals increase market exposure following strong returns and reduce it after losses, leading to suboptimal timing and missed opportunities.

• Home bias is prevalent among investors, who prefer local stocks despite lacking superior information about them, resulting in poor diversification and reduced portfolio efficiency.

• Overconfidence causes investors to trade excessively, and data shows that high-frequency traders typically earn worse returns than those who trade less frequently.

• Herd behavior is common, with investors often buying or selling the same stocks simultaneously, which amplifies market inefficiencies and can harm returns.

• Many investors chase past performance, moving their money into funds that have recently performed well, often too late to benefit from continued outperformance.

• Despite the availability of lower-cost options, investors frequently allocate funds to expensive products, ignoring predictable performance characteristics and reducing overall investment efficiency.

In summary, the article is a good primer on behavioral finance. It discusses, in particular, the investment mistakes that cause investors to lose money.

Reference

[1] Firth, Chris, An Introduction to Investment Mistakes (2015). SSRN 2609989

Retail Options Traders’ Behavior

Retail investors are individual, non-professional investors who buy and sell securities, such as stocks, options, and mutual funds, for their accounts rather than for an organization or institution. Unlike institutional investors, who manage large sums of money on behalf of clients or large entities, retail investors typically trade in smaller quantities and often use online brokerage accounts to facilitate their transactions.

A considerable amount of research has been devoted to studying retail investors’ behavior. A recent paper by the CBOE [2] utilizes the exchange’s data and refutes some academic research findings.

Findings

• Retail investor participation in the options market increased notably from 18% to 31% between the fourth quarter of 2019 and the fourth quarter of 2023.

• Complex orders made up 58% to 76% of retail open positions, challenging the belief that retail traders primarily hold simple long positions.

• Academic studies often miss complex retail trading activity due to reliance on limited datasets or assumptions that overlook retail investor sophistication.

• Retail traders show a wider range of strategies than previously thought, including multi-leg options trades and hedging techniques, indicating greater versatility.

• The study found that the assumption that retail investors lack sophistication is outdated, as many use advanced tools and approaches for managing risk.

• Market maker order imbalance in SPX options declined from -14% in December 2016 to -12% in May 2023, even with increased use of 0DTE options.

• This decline in imbalance suggests the growth of 0DTE SPX options has not disrupted market maker order flow, contrary to popular belief.

• When SPX options are excluded, retail trading still represented 32% to 40% of all non-SPX options traded on the C1 exchange by notional value.

• The use of CBOE’s internal data offers a more accurate and complete view of retail investor behavior compared to earlier studies relying on proxies.

• Overall, the findings indicate retail investors are more active, strategic, and integral to the options market than traditional views have assumed.

This research by the CBOE, using more complete data, sheds light on the behavior of retail options traders. It provides more insight into the changing dynamics of the options markets.

Reference

[2] Selina Han, Unveiling the Sophistication: Understanding Retail Investors’ Trading Behavior in the U.S. Options Market, May 2024, CBOE

Closing Thoughts

In summary, the first article serves as a solid introduction to behavioral finance, focusing on the common mistakes that lead to investor losses. The second article presents CBOE research that, using more complete data, offers a clearer view of retail options trading behavior and the evolving structure of the options market.

Educational Video

Behavioral Finance and the Role of Psychology

In this video, Professor Shiller challenges the assumption of rationality in finance, highlighting human biases and the moral checks on exploitative behavior, referencing Adam Smith’s The Theory of Moral Sentiments. He introduces key behavioral finance concepts, including Prospect Theory by Kahneman and Tversky, overconfidence, Regret Theory, gambling behavior, cognitive dissonance, anchoring, representativeness, and social contagion. The lecture concludes with reflections on moral judgment, shared values, and integrity in business.

Volatility Weekly Recap

The figure below shows the term structures for the VIX futures (in colour) and the spot VIX (in grey).

The S&P 500 began the week on a quiet note but experienced some volatility midweek following reports of a potential political decision regarding the Fed. However, upward momentum resumed on Thursday. Friday saw a slight pullback, but markets still finished higher. The S&P 500 gained 0.59%, and the Nasdaq rose 1.51%. Oil prices pulled back early in the week but then rebounded. Gold experienced another relatively quiet week. Crypto had another strong showing, with Bitcoin briefly touching $123,000.

On the volatility front, both spot and VIX futures remained in contango, and the roll yield stayed firmly positive. However, mid-term futures rose slightly while short-term futures declined, resulting in returns of -0.42% and 1.99% for VXX and VIXM, respectively.

Around the Quantosphere

• How to get a job in private equity. (Efinancialcareers)

• 7 Things HFT Quants Need to Know About OpenAI Before Accepting a Role (efinancialcareers)

• Apollo Wins Bid for Singapore’s $1 Billion Private Credit Fund (Yahoo Finance)

• This former quant trader spent years raising alarms about Treasury-market manipulation. He says problems likely persist. (Morningstar)

• Credit traders used to make $10m for the bank, $1m for themselves. Algos ruined that. (Efinancialcareers)

• The hedge fund manager who earned $100m working remotely in the countryside (Efinancialcareers)

• The $2 Billion Bet on AI-Driven Fintech: Why Murati's Startup Signals a New Era in Financial Innovation. (Ainvest)

• How to run a cross-asset desk in 2025 (Gobaltrading)

• The newly dynamic world of hedge fund fees. (Ig)

Disclaimer

This newsletter is not investment advice. It is provided solely for entertainment and educational purposes. Always consult a financial professional before making any investment decisions.

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