# Prospect Theory ⎊ Area ⎊ Resource 2 --- ## What is the Decision of Prospect Theory? Prospect theory provides a framework for understanding how traders make financial decisions under uncertainty, particularly in high-stakes derivatives markets. It suggests that individuals evaluate potential outcomes relative to a reference point, such as their initial investment or recent portfolio value, rather than absolute wealth. This model explains why traders often deviate from the predictions of traditional rational choice theory. ## What is the Risk of Prospect Theory? A core tenet of prospect theory is loss aversion, where the psychological impact of a loss is significantly greater than the pleasure derived from an equivalent gain. This leads traders to exhibit risk-averse behavior when facing potential gains, often selling winning positions too early, while becoming risk-seeking when facing potential losses, holding onto losing positions in hopes of recovery. ## What is the Bias of Prospect Theory? Prospect theory highlights several behavioral biases, including the disposition effect, where traders are reluctant to realize losses and eager to realize gains. In options trading, this can manifest as holding onto out-of-the-money options that are rapidly losing value. Understanding these biases is essential for developing disciplined trading strategies that counteract innate human tendencies. --- ## [Equilibrium Pricing](https://term.greeks.live/definition/equilibrium-pricing/) ## [Behavioral Finance Biases](https://term.greeks.live/term/behavioral-finance-biases/) ## [Probability](https://term.greeks.live/definition/probability/) ## [Behavioral Game Theory Analysis](https://term.greeks.live/term/behavioral-game-theory-analysis/) --- ## Raw Schema Data ```json { "@context": "https://schema.org", "@type": "BreadcrumbList", "itemListElement": [ { "@type": "ListItem", "position": 1, "name": "Home", "item": "https://term.greeks.live" }, { "@type": "ListItem", "position": 2, "name": "Area", "item": "https://term.greeks.live/area/" }, { "@type": "ListItem", "position": 3, "name": "Prospect Theory", "item": "https://term.greeks.live/area/prospect-theory/" }, { "@type": "ListItem", "position": 4, "name": "Resource 2", "item": "https://term.greeks.live/area/prospect-theory/resource/2/" } ] } ``` ```json { "@context": "https://schema.org", "@type": "WebSite", "url": "https://term.greeks.live/", "potentialAction": { "@type": "SearchAction", "target": "https://term.greeks.live/?s=search_term_string", "query-input": "required name=search_term_string" } } ``` ```json { "@context": "https://schema.org", "@type": "FAQPage", "mainEntity": [ { "@type": "Question", "name": "What is the Decision of Prospect Theory?", "acceptedAnswer": { "@type": "Answer", "text": "Prospect theory provides a framework for understanding how traders make financial decisions under uncertainty, particularly in high-stakes derivatives markets. 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