Option Trading Blog

The following example is taken from the work of Kahneman and Tversky:

Consider the following scenario: Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which is more likely?

1. Linda is a bank teller.
2. Linda is a bank teller and is active in the feminist movement.

If you answered 2, you were wrong. Kahneman and Tversky coined this the conjunction bias although it is just a matter of probability rules we were (hopefully) taught in highschool. The probability of one event happening is greater than the probability of two events happening in conjunction. More intuitively, imagine the group of all bank tellers. Wouldn’t you agree that the group of bank tellers includes also the group of active feminists? so the group of active feminists inside the group of bank tellers is smaller.

Conjunction bias in trading

What does it have to do with trading you ask? it has everything to do with trading. Especially in volatile days when investors and traders make the wrong decisions just because the above bias. For example, recall that a month ago the market was VERY volatile and it seemed all the world markets would collapse.
If I were to ask you back then what is more likely:

1. A drop in the market of more than 3%
2. A drop in the market of more than 1%

If you answered 1, then you were wrong. This is because although the market was very volatile and it seemed that a drop of more than 3% was very likely, for it to drop more than 3% it has to first drop 1%! hence option 2 is ALWAYS more likely.

How to apply it

To apply it, you have to be aware it exists. For instance, consider options. If people think a 3% drop is more likely, put options deep in the money should be expensive relative to at the money options. This happens mostly in volatile situations as described above. As a good exercise, you could think of other situations where anomalies in prices occur due to the above bias.