Published September 19th, 2007
in Efficient Market.
The following example is taken from the work of Kahneman and Tversky:
Consider the following scenario: Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.
Which is more likely?
- Linda is a bank teller.
- Linda is a bank teller and is active in the feminist movement.
If you answered 2, you were wrong. Kahneman and Tversky coined this the conjunction bias although it is just a matter of probability rules we were (hopefully) taught in highschool. The probability of one event happening is greater than the probability of two events happening in conjunction. More intuitively, imagine the group of all bank tellers. Wouldn’t you agree that the group of bank tellers includes also the group of active feminists? so the group of active feminists inside the group of bank tellers is smaller.
Conjunction bias in trading
What does it have to do with trading you ask? it has everything to do with trading. Especially in volatile days when investors and traders make the wrong decisions just because the above bias. For example, recall that a month ago the market was VERY volatile and it seemed all the world markets would collapse.
If I were to ask you back then what is more likely:
- A drop in the market of more than 3%
- A drop in the market of more than 1%
If you answered 1, then you were wrong. This is because although the market was very volatile and it seemed that a drop of more than 3% was very likely, for it to drop more than 3% it has to first drop 1%! hence option 2 is ALWAYS more likely.
How to apply it
To apply it, you have to be aware it exists. For instance, consider options. If people think a 3% drop is more likely, put options deep in the money should be expensive relative to at the money options. This happens mostly in volatile situations as described above. As a good exercise, you could think of other situations where anomalies in prices occur due to the above bias.
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Published September 18th, 2007
in Making Money With Options.
Before you start yelling at me and tell me how can I say they are not good investment if I myself trade them, let me explain what I mean by that. It is true that I trade options, but only for short term trading. I usually get rid of my options in the same day. Let us consider the situation where a person thinks a stock should rise in value in the future. Instead of buying the stock itself, he wants to buy a call option on the stock. A person might do this because of the leverage an option provides.
Some Option Drawbacks
It is true that options provide leverage that can boost profits. The problem is that, unlike a stock, they can lose value pretty quickly and even if the move you waited to happen has happened, you might not profit from it.
Losing Value With Time
Unlike a stock, the option loses value with time. Intuitively, this is because the option has less probability to finish inside the money as time progresses.
Losing Value If Implied Volatility Changes
Lower implied volatility means less chance that the option will finish inside the money, hence causing it’s price to decline.
The above should be a reminder on how NOT to trade options. You don’t buy an option to sit back and look how the option rises in value.
Some Exceptions
Exceptions naturally occur when you use options as hedging tools in conjunction with stocks. Buying a stock and buying a
put is a fairly good idea for the risk averse investor.
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Published September 15th, 2007
in Finance.
Happy new Jewish year!
I have come across a news article in Hebrew on some predictions of analysts to the upcoming year. As always it serves for good laughs and fun. As you already know, I consider those prediction to equivalent of witchcraft.
One Economist says that 2008 would be a very tough year because of the slow growth in the US economy and the sub-prime crisis. Classic after the fact analysis. Who ever heard about the sub-prime crisis before it happened?
Another Economist, called the “optimistic” one by the reporter, predicts that the local stock market would rise between 12%-17%. I have really no idea where these people get those numbers. It is pretty pretentious if you ask me.
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