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The Skinny on Options: Abstract Applications

Prospect Theory: The Emotional Element of Trading

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.

We would all like to think we are robotic in our decision-making, and we always make the most rational choice. But, that is simply not the case, as we are emotional beings. Not to mention, neuroscience reminds us that our prefrontal cortex (the area of our brains that is responsible for rational decision-making) and our limbic system (the area of our brains that controls emotional responses) share an inverse relationship. In other words, the more we use one, the less we use the other. So, when we are highly emotional and need our rational decision-making abilities the most, our brains don’t work like we would hope. Further, if we’re in a panicked stated and our amygdala lights up, then we’ll resort to our minimum level of basic training.

All of this leads us to Prospect Theory, which effectively postulates that we do not process our winners and losers the same way. Specifically, for a given loss, the pain that we feel exceeds the pleasure we would derive from the same amount of gain. As tastytraders, this supports the notion that we need to trade small, trade often, in an effort to gain more comfort with rolling and adjusting those losers. Furthermore, the more time we can devote to learning this space, the higher our level of basic training, and thus the better chance we give ourselves to make good choices in times of extreme market duress.

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