Stupidity in the world of available information
...or how to trade binary options when you understand the base risk
So, in my last post I used stupidity to refer to biases that do not allow people to make optimal decisions. As noticed, this is just the way humans operate and in many instances it is to be expected...
Binary options trading under influence
I have also mentioned that in binary options, trading outcomes are subject to considerable risk. I have also mentioned the fact that in many cases customers do not have all the relevant information to understand what kind of risks they face. In a sense, this information asymmetry arises from the lack of information one party, usually the trader, has to make a decision.
What about binary options traders who have all the information
So, you are a binary options trader that understands the odds and you still want to have fun trading binary options, applying technical analysis you remember from college or that free webinar on youtube. You may be using some of the resources binary options websites put forward for traders to use. You like that one strategy and think you could apply it on this emerging market currency pair.
In this situation, technical analysis may provide a possible future price (exchange rate) path for the pair. There is also this other major pair that can be analysed too, however, the emerging markets just look as a great chance since extreme price moves they are subject to, seem to be able to offer a nice opportunity to score at favored expiry time.
Long shot bias in binary options trading
In this situation, the technical analysis seems to indicate the probability of a predictable price move in an emerging market currency pair have risen, and maybe a unique set of circumstances at that moment warrants that outlook.
However, each price path has a probability tied to it. So does the one selected by the technical analysis. The probability of a predictable move may have risen, but id still does not necessarily make it a better position than the major pair that has seen a similar probability of prediction rise.
It is simple, while the emerging markets pair probability rose from a very low level just for a small amount, due to volatility they usually carry, it is still well below the major pair that may have seen the probability rise from a higher level. Traders in binary options under influence from long-shot bias tend to pick the pair with a probability that is actually lower, thereby lowering their chances of a successful trade.
HBR nicely summarises this when referring to pioneering work done by Kahneman and Tversky
In the famous 1979 paper in which they presented their Prospect Theory, they noted that people’s ability to perceive differences between extreme probabilities was far greater than their ability to notice differences between intermediate ones. The difference between 0% and 1%, for example, is much more salient than that between 10% and 11%, and the difference between 99% and 100% looms much larger than that between 89% and 90%.
So, when choosing your next position, make sure you think of the probability level for your asset. Long shots may seem like a better choice, but as explained, it's not the wisest choice.
When trading, favorites are a good pick because you probably are not trading them enough*
Same thing goes in the opposite direction, turning to HBR again,
punters tend to value long shots more than they should, given how rarely they win, while valuing favorites too little given how often they win.
*Disclaimer: even without naming any assets, this should not bee seen as a trading advice. For advice on investments, look for a licensed advisor in your country.
