Are disposition effect and skew preference correlated? Evidence from account‐level ELW transactions

• Date: 01 February 2020
• Author: Eunji Kwon,Woojin Kim,Youngsoo Choi
• DOI: http://doi.org/10.1002/fut.22055
• Published date: 01 February 2020

J Futures Markets. 2020;40:228–246.wileyonlinelibrary.com/journal/fut228

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© 2019 Wiley Periodicals, Inc.

Received: 15 August 2019

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Accepted: 24 August 2019

DOI: 10.1002/fut.22055

RESEARCH ARTICLE

Are disposition effect and skew preference correlated?

Evidence from account‐level ELW transactions

Youngsoo Choi

1

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Woojin Kim

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Eunji Kwon

1

1

Hankuk University of Foreign Studies,

Mohyeon‐myeon, Cheoin‐gu, Yongin‐si,

Gyeonggi‐do, Korea

2

Seoul National University Business

School, Gwanak‐gu, Seoul, Korea

Correspondence

Youngsoo Choi, Hankuk University of

Foreign Studies, 81 Oedae‐ro,

Mohyeon‐myeon, Cheoin‐gu,

Yongin‐si, Gyeonggi‐do 449‐791, Korea.

Email: choiys@hufs.ac.kr

Funding information

Hankuk University of Foreign Studies

Research Fund; Institute of Management

Research at Seoul National University,

Institute of Finance and Banking of Seoul

National University

Abstract

This paper examines whether two well‐known cognitive biases, disposition

effect and skew preference, may reflect a common feature of certain investors.

On the basis of a unique proprietary dataset that provides the details of all

transactions in the Korean equity‐linked warrant (ELW) market between 2009

and 2011, we find that investors who realize gains faster than losses are also

more likely to trade out‐of‐the‐money ELWs. Investors who are less (more)

subject to both biases exhibit the best (worst) risk‐adjusted trading performance.

Our findings suggest that disposition effect and skew preference occur

simultaneously, which could adversely affect trading performance.

KEYWORDS

disposition effect, equity‐linked warrant, Korea, lottery, option, skew preference

JEL CLASSIFICATION

G13; G23; G41

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INTRODUCTION

A growing literature in behavioral finance suggests that various forms of cognitive biases exist among investors,

especially among individual investors. Two of the most widely discussed behavioral biases are the disposition effect, a

tendency to sell winners and hold onto losers, and the preference for skewed return or lottery‐type payoffs.

Recent studies suggest that the degree of disposition effect or skew preference may vary across different investor

clientele. For example, Bailey, Kumar, and Ng (2011) find that individuals with socioeconomic characteristics that are

likely to induce gambling—namely poor, young, and less‐educated investors—prefer low‐priced stocks with high

volatility and high skewness. Dhar and Zhu (2006) report that wealthy, professional individuals, as well as investors

who trade more frequently, exhibit less disposition effect. Fischbacher, Hoffmann, and Schudy (2017) document that

investors who commit to realize a loss in advance by voluntarily signing up for automatic selling mechanisms are also

less subject to disposition effect.

Another stream of literature examines how prior financial performance may influence subsequent risk‐taking.

Although many studies report that experiencing financial losses may lead to more risk aversion, some studies find that

losers are more risk‐seeking than winners.

1

A recent experiment by Imas (2016) formally distinguishes between realized

and paper losses and finds that it is the latter that leads to more subsequent risk‐taking, but not the former. These

studies jointly suggest that disposition effect and skew preference may not be independent behavioral biases but rather

reflect a correlated behavior, potentially more distinct among less sophisticated investors.

1

For example, Andersen, Hanspal, and Nielsen (2019) and Guiso, Sapienza, and Zingales (2018) report a positive relationship between past performance and risk‐taking, whereas Chatrath, Christie‐

David, Miao, and Ramchander (2019) find a negative relationship.

Cumulative prospect theory in Tversky and Kahneman (1992) and Barberis (2012) lays the groundwork for a

theoretical prediction that losers may engage in more risk‐taking than winners due to a dynamic inconsistency in

preference. Nevertheless, empirical study that explicitly considers both disposition effect and skew preference as

common characteristics of a certain class of investors is extremely scant.

2

The lack of such study is presumably due to

unavailability of an appropriate dataset that can simultaneously measure an investor’s susceptibility to both disposition

effect and skew preference. For example, detailed information on account‐level transactions is required to construct a

measure of the disposition effect. In addition, we need a measure of ex ante skewness of a return distribution to proxy

for skew preference.

3

In this study, we take advantage of a unique dataset that allows one to test the potential coexistence of both

disposition effect and skew preference, and how they affect trading performance. Our tests are based on a

proprietary dataset from the Korean equity‐linked warrant (ELW) market, which provides detailed trading records

at each account level. Our dataset includes account identifiers for both the buyer and the seller, which allows us to

directly track the trade history and the dollar amount gains and losses to each and every account in our sample.

4

Specifically, our dataset includes all trades and quotes of ELWs listed in the Korea Exchange from January 2, 2009

to June 30, 2011. There are a total of more than 94,000 accounts available, out of which 53,620 accounts trade ELWs

based on individual stocks.

ELWs are very similar to standard equity options in terms of the strike price, maturity, underlying assets, and payoff

structure, except that they are created and sold by securities companies. Once sold, they are listed on the stock

exchange, rather than on options exchange, and they trade just like any other stock so that no margin is required as in

standard options trading. However, retail investors can only initially buy ELWs and cannot take short positions. As

such, conventional option trading strategies, like writing covered calls or creating various types of spreads, are not

feasible.

According to a recent model developed by Boyer and Vorkink (2014), ex ante skewness of an option can be proxied

by its (out‐of‐the) moneyness. Since ELWs are essentially options that allow only long positions, we can measure an

investor’s skew preference by the average moneyness of the ELWs purchased.

And since we can identify gains and losses in our transaction‐level dataset, we can also construct a measure of the

disposition effect. We construct a measure of the disposition effect, similar to those developed in Shefrin and Statman

(1985) and Shapira and Venezia (2001) as follows. We classify all sell transactions in our dataset into a gain, loss, or a

draw, and conditional on each outcome, calculate the length of the round‐trip holding period from the initial purchase.

Then, for each account in our sample, we obtain the average holding periods for losses and gains, and take the ratio of

average time until losses over average time until gains as a measure of the disposition effect. This measure precisely

reflects how losers are held longer compared with winners.

Consistent with the previous literature, we find that our ELW investors indeed exhibit a disposition

effect on average. For example, the mean (median) round‐trip holding period for a transaction incurring a

loss is more than 5 (close to 2) times longer than the corresponding length for a transaction with a gain. In

roughly 80% of our sample accounts, average time held until a loss is longer than average time held until

again.

In addition, we find that disposition effect is more pronounced when a given account purchases more out‐of‐

the‐money ELWs, which is a measure of ex ante skew preference based on Boyer and Vorkink (2014). This is

broadly consistent with experimental evidence provided in Imas (2016), where individuals engage in more risk‐

taking following a paper loss. Both disposition effect and skew preference are strongeramonginvestorswhotradea

smallernumberofELWsorunderlyingassets,aproxyforinvestor sophistication. The positive correlation between

disposition effect and skew preference holds after controlling for additional account‐level characteristics in a

multivariate framework.

More importantly, both disposition effect and ex ante skew preference of an account adversely affect its

risk‐adjusted trading performance. There have been some studies that examine how skew preferences may affect

performance (e.g., Bailey, Kumar, & Ng, 2011), but very few studies examine how disposition effect may affect

2

Two related studies are Imas (2016), who examines risk‐taking behavior subsequent to paper losses in an experimental setting, and Chatrath et al. (2019), who examine the link between option

traders’performance, pricing of their holdings, and potential disposition effect.

3

Ex post skewness obtained from realized returns of an investor’s portfolio is positively correlated with realized performance of that portfolio by construction, since it contains at least one large realized

gain. As such, it cannot be used to proxy for investors’ex ante behavioral biases.

4

This approach is similar to Barber and Odean (2000) and Baron, Brogaard, and Kirilenko (2012).

CHOI ET AL.

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