Prospect Theory in Trading

Prospect Theory is a behavioral economic theory that describes how people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are unknown. It suggests that people value gains and losses differently, leading to inconsistent decision-making.

Specifically, people are more sensitive to losses than they are to equivalent gains, a phenomenon known as loss aversion. In trading, this leads to the tendency to hold onto losing positions for too long in the hope of breaking even, while selling winning positions too early to lock in gains.

Contrarian traders must actively fight these biases to be successful. By using objective, rules-based strategies, they can overcome the psychological traps identified by prospect theory.

It is a framework for understanding why traders make irrational decisions and how to build systems that bypass these cognitive flaws.