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Prospect Theory for Online Financial Trading

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  • Yang-Yu Liu
  • Jose C. Nacher
  • Tomoshiro Ochiai
  • Mauro Martino
  • Yaniv Altshuler
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    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 risk-averse with respect to gains and risk-seeking with respect to losses, 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 them 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 loss aversion phenomenon, an essence 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 effect of loss aversion. Moreover, we introduce three risk-adjusted metrics inspired by prospect theory 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 statistically based on their historical trading behavior rather than their trading performance at any given point in time.

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    File URL: http://arxiv.org/pdf/1402.6393
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1402.6393.

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    Date of creation: Feb 2014
    Date of revision: Mar 2014
    Handle: RePEc:arx:papers:1402.6393

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    1. Schmidt, Ulrich & Traub, Stefan, 2002. " An Experimental Test of Loss Aversion," Journal of Risk and Uncertainty, Springer, Springer, vol. 25(3), pages 233-49, November.
    2. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, Econometric Society, vol. 47(2), pages 263-91, March.
    3. U Schmidt & H Zank, 2002. "What is Loss Aversion?," The School of Economics Discussion Paper Series, Economics, The University of Manchester 0209, Economics, The University of Manchester.
    4. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, Springer, vol. 5(4), pages 297-323, October.
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