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Prospect Theory for Online Financial Trading

Author

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  • Yang-Yu Liu
  • Jose C Nacher
  • Tomoshiro Ochiai
  • Mauro Martino
  • Yaniv Altshuler

Abstract

Prospect theory is widely viewed as the best available descriptive model of how people evaluate risk in experimental settings. According to prospect theory, people are typically risk-averse with respect to gains and risk-seeking with respect to losses, known as the “reflection effect”. People are much more sensitive to losses than to gains of the same magnitude, a phenomenon called “loss aversion”. Despite of the fact that prospect theory has been well developed in behavioral economics at the theoretical level, there exist very few large-scale empirical studies and most of the previous studies have been undertaken with micro-panel data. Here we analyze over 28.5 million trades made by 81.3 thousand traders of an online financial trading community over 28 months, aiming to explore the large-scale empirical aspect of prospect theory. By analyzing and comparing the behavior of winning and losing trades and traders, we find clear evidence of the reflection effect and the loss aversion phenomenon, which are essential in prospect theory. This work hence demonstrates an unprecedented large-scale empirical evidence of prospect theory, which has immediate implication in financial trading, e.g., developing new trading strategies by minimizing the impact of the reflection effect and the loss aversion phenomenon. Moreover, we introduce three novel behavioral metrics to differentiate winning and losing traders based on their historical trading behavior. This offers us potential opportunities to augment online social trading where traders are allowed to watch and follow the trading activities of others, by predicting potential winners based on their historical trading behavior.

Suggested Citation

  • Yang-Yu Liu & Jose C Nacher & Tomoshiro Ochiai & Mauro Martino & Yaniv Altshuler, 2014. "Prospect Theory for Online Financial Trading," PLOS ONE, Public Library of Science, vol. 9(10), pages 1-7, October.
    • Handle: RePEc:plo:pone00:0109458
    DOI: 10.1371/journal.pone.0109458
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    References listed on IDEAS

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    Cited by:

    1. Scheckenbach, Isabel & Wimmer, Maximilian & Dorfleitner, Gregor, 2021. "The higher you fly, the harder you try not to fall: An analysis of the risk taking behavior in social trading," The Quarterly Review of Economics and Finance, Elsevier, vol. 82(C), pages 239-259.
    2. Karolina Puławska, 2022. "Effects of the bank levy introduction on the interbank market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 27(1), pages 844-864, January.
    3. Cheng, Xiu & Long, Ruyin & Chen, Hong, 2020. "A policy utility dislocation model based on prospect theory: A case study of promoting policies with low-carbon lifestyle," Energy Policy, Elsevier, vol. 137(C).
    4. James Schmitz & David Rothschild, 2019. "Understanding market functionality and trading success," PLOS ONE, Public Library of Science, vol. 14(8), pages 1-28, August.
    5. Aneta Hryckiewicz & Piotr Mielus & Karolina Skorulska & Malgorzata Snarska, 2018. "Does a bank levy increase frictions on the interbank market?," KAE Working Papers 2018-033, Warsaw School of Economics, Collegium of Economic Analysis.
    6. Jose Apesteguia & Jörg Oechssler & Simon Weidenholzer, 2020. "Copy Trading," Management Science, INFORMS, vol. 66(12), pages 5608-5622, December.
      • Jose Apesteguia & Jörg Oechssler & Simon Weidenholzer, 2018. "Copy Trading," Working Papers 1048, Barcelona School of Economics.
      • Jose Apesteguia & Jörg Oechssler & Simon Weidenholzer, 2018. "Copy trading," Economics Working Papers 1615, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2019.
    7. Florian Röder & Andreas Walter, 2019. "What Drives Investment Flows Into Social Trading Portfolios?," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 42(2), pages 383-411, July.
    8. Kromidha, Endrit & Li, Matthew C., 2019. "Determinants of leadership in online social trading: A signaling theory perspective," Journal of Business Research, Elsevier, vol. 97(C), pages 184-197.
    9. Pelster, Matthias & Hofmann, Annette, 2018. "About the fear of reputational loss: Social trading and the disposition effect," Journal of Banking & Finance, Elsevier, vol. 94(C), pages 75-88.
    10. Ambler, Kate & Godlonton, Susan & Recalde, María P., 2021. "Follow the leader? A field experiment on social influence," Journal of Economic Behavior & Organization, Elsevier, vol. 188(C), pages 1280-1297.
    11. Dorfleitner, Gregor & Fischer, Lukas & Lung, Carina & Willmertinger, Philipp & Stang, Nico & Dietrich, Natalie, 2018. "To follow or not to follow – An empirical analysis of the returns of actors on social trading platforms," The Quarterly Review of Economics and Finance, Elsevier, vol. 70(C), pages 160-171.
    12. Benjamin M Blau & Ryan J Whitby, 2017. "Range-based volatility, expected stock returns, and the low volatility anomaly," PLOS ONE, Public Library of Science, vol. 12(11), pages 1-19, November.
    13. Fabiana Fragnito, 2023. "Copytrading, a New Phenomenon: Comparative Economic and Legal Overview," Economic Thought journal, Bulgarian Academy of Sciences - Economic Research Institute, issue 4, pages 431-445.
    14. Apesteguia, Jose & Oechssler, Jörg & Weidenholzer, Simon, 2018. "Copy Trading," Working Papers 0649, University of Heidelberg, Department of Economics.

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