A very common behavioral bias is called “Anchoring.” In short, anchoring means that humans tend to place too much emphasis on whatever data is easily available to them, whether that data is relevant?to the decision at hand or not. [1]
Anchoring plays a part in investing in all asset classes, and options are no different.
Consider this example: you are thinking about investing in the call options of a company that has seen historical volatility pretty steady at 35% per annum. Calls that are pretty far out of the money (OTM) are trading right now for $1, which works out to a 65% rate of annualized implied volatility. Would you buy the call option?
The important question to ask when faced with a situation like this is not whether 65% is unacceptably greater than 35%, but rather what return will be generated on the $1 of investment capital. As long as we expect to generate a positive return on our investment, we should?as intelligent option investors?be willing and happy to invest the dollar.
For example, if, in the above example, you were told that, by spending the $1 in premium, there was a 70% chance of winning $3, what would you think? Clearly, the most important number to you would not be the ?65% Implied Volatility? but rather the ?70% chance of tripling one?s money.?
“Tripling one’s money” implies?that the realized volatility will be very high–higher than the volatility as implied by the market. For more information about the difference between implied and realized volatility, see my post Implied Volatility is Unimportant.
NOTES
[1] A great example of anchoring is given by Nobel prize winner Daniel Kahneman in his 2011 book Thinking, Fast and Slow:
The power of random anchors has been demonstrated in some unsettling ways. German judges with an average of more than fifteen years of experience on the bench first read a description of a woman who had been caught shoplifting, then rolled a pair of dice that were loaded so every roll resulted in either a 3 or a 9. As soon as the dice came to a stop, the judges were asked whether they would sentence the woman to a term in prison greater or lesser, in months, than the number showing on the dice. Finally, the judges were instructed to specify the exact prison sentence they would give to the shoplifter. On average, those who had rolled a 9 said they would sentence her to 8 months; those who rolled a 3 said they would sentence her to 5 months; the anchoring effect was 50%.
The startling thing about this is that the piece of information given to the judges–the outcome of a die roll–had absolutely zero relationship to the question at hand–namely, how severe of a penalty did the accused deserve. Still, simply being shown a number did end up measurably influencing the final decision of the judge.
Moral of the story? If ever on trial for something you are indeed guilty of, wear a pin or a button with a “1” inscribed on it large enough to be seen by the judge…