Optimism Does Not Pay Off on the Trading Floor

Optimism may help when securing jobs or promotions, but not on the option trading floor as a new research paper by Swiss Finance Institute Professor Paul Schneider from the Università della Svizzera Italiana reveals. He connects subjective views such as optimism and pessimism with prices and trading strategies in the options market. He finds pessimists to be far and away the most successful, with optimists being their unfortunate counterparties. Perhaps surprisingly, the pessimist’s success is based upon his or her role as insurance vendor.

Swiss Finance Institute Professor Paul Schneider from the Università della Svizzera Italiana developed a framework in which he takes quoted bid–ask spreads in the liquid S&P 500 options market as input and investigates how different subjective views imply risk preferences, and consequently trading strategies. In his model, the options market is populated by optimists, pessimists, and pragmatists. The optimist believes in the exceptional upside potential of the market, while the pessimist believes disaster is highly likely; the pragmatist believes that the market does not quote a certain region of option strikes by accident and hence considers it the most informative.

Schneider finds that the three types of agents use a surprisingly small variety of strategies. With few exceptions, pessimists short both the S&P 500 itself and variance swaps, with the optimists as their counterparty. The pragmatists fill in the trading gaps opportunistically. This market-clearing allocation in variance comes as a surprise: the generally accepted interpretation of the negative variance premium in the S&P 500 market is as an insurance premium against market crashes. To appreciate the background to these unexpected trading allocations, one ought to discard the notion that pessimists are necessarily more downside risk averse than optimists. Likewise, optimists are not necessarily more risk loving. Analogies are easy to find. Pessimists may pack their bathing suits and beach towels despite their expecting bad weather. In contrast, optimists decide to leave them at home, because they simply do not want to be bothered by the extra weight, despite their strong expectations of a sunny day. Downside risk aversion is the most prominently and robustly observed trait of human decision-making, but there is a great variation in its strength that is not necessarily connected to expectations. Positive thinking, it is clear, does not always pay off. On the option trading floor, it seems, optimism all by itself is rather unhelpful.

The full version of the May issue of SFI’s Practitioner Roundups is available at: http://sfi.ch/system/tdf/Roundup_May18_English.pdf?file=1