The Skinny on Options: Abstract Applications

Fear Conditioning and Extinction

The Skinny on Options: Abstract Applications

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

For as black/white and cut/dry as we make trading, there will always be an unavoidable emotional element. We saw this with Prospect Theory, and how we tend to process gains and losses very differently. Today, we continue that discussion by digging deeper into behavioral psychology and the biases we develop, with the ideas of Fear Conditioning and Fear Extinction.

Simply put, both Fear Conditioning and Fear Extinction are learned behaviors. If we walk into an outlier move with our short premium position, we can be conditioned to associate fear with short premium. Similarly, if we nail a stock’s direction with a long premium trade, we can be conditioned to think we can predict direction. Both of these associations do not depict reality, and would thus need to be unlearned over time.

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