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Monkey Markets - What Do They Mean for Investors

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The latest TED video on how monkey economy participants function like their Homo Sapien cousins has made the rounds:

  • When offered the chance to gamble on the upside, monkeys (and humans) usually pass, and take the sure thing.


  • When offered the chance to gamble on the downside i.e. take a sure loss or gamble to limit the loss, monkeys (and humans) usually gamble.

The payoffs from these individual exchanges are identical, it is just the framing of the question - "gain" versus "loss". And that is always contextual.
So how can we boil this into "market speak".

How do these payoff profiles resemble options?

  1. Increased upside is the hallmark of a long call option - the participant buys a call. Monkeys and humans sell this - they sell calls on the potential economic outcome. Increased gain does not interest them.

  2. What about on the downside? Monkeys have the choice of "buying insurance" ie. limiting loses and preserving some of their gains. This is commonly referred to as a put. The monkeys (and humans) have the choice to buy a put, but more often than not, they forgoe this opportunity, and "let it ride" in the hope of a winning outcome.

Monkey/Human bias is to sell calls on their existing positions and leave their downside exposed. Using put/call parity equations,
Stock + Put = Cash + Call
rearranging the elements we get:
Stock - Call = Cash - Put
So monkeys and humans instinctively (and therefore synthetically) sell puts by maintaing this bias.

Do the facts bear this out? Yes. More than 90% of quant and stat-arb strategies are net sellers of options (see Taleb et al). Now not all these guys might feel comfortable with this strategy, but this is what the boss and investors want. And who can blame them - it is a strategy that conforms to existing biases.
It is interesting to note that Taleb's first fund - Empirica - was oft ridiculed for taking the opposite side, and buying truckloads of cheap options. It worked, eventually. He was fighting 35 million years of evolution after all.

So how to make use of this?

  1. Be aware that your instinct is to take the sure thing - sell stock/funds too early, etc.

  2. Be aware that your instinct is to expose yourself on the downside - insurance is good. If you have company stock that you are planning to use to fund a future home purchase, do not risk that money. Either buy puts, or sell enough stock to reasonably meet your goals, but retain enough stock to "let it ride" and participate in the upside.

  3. In addition, remember that the payoffs to the monkeys were identical - it was the framing that determined their decision. Am I losing something that has been temporarily given to me (in which case I will gamble), or am I looking at more than I have already been given (in which case I tend to take the sure thing)? Stock grants and 401k matches and IRA tax-free investing have a very different impact on investor decisions than if they were given the cash equivalent and went into the marketplace to buy securities. This is a powerful bias driving both institutional and retail investor behavior.

FundKing knew many many market participants who were paid in broker/bank stock, and now regret that decision. Hank Paulson, when being confirmed for Secretary of Treasury, boasted that he had "never sold a single share of Goldman stock in my time at the firm". That was the culture, and it bit almost everybody else in the ass.

Monkeys on Wall Street will tend to sell options, in a variety of contexts. As a market participant, you should strive to buy these cheap options,to both maximize your upside (do not sell calls) and limit your downside (buy puts when prudent).

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Guest Sunday, 12 July 2020