Prospect Theory Simulator

Understanding Prospect Theory

Prospect Theory explains how people make decisions involving risk, showing that:

• People value gains and losses differently (loss aversion)
• People overweight small probabilities and underweight large ones
• Decisions are made relative to a reference point (usually the status quo)

The value function in Prospect Theory is typically S-shaped:

V(x) = x^α for gains, -λ(-x)^β for losses

Where:

• V(x) = subjective value
• α, β = parameters for diminishing sensitivity (usually < 1)
• λ = loss aversion coefficient (usually > 1)

In options trading, this explains why traders might hold losing positions too long (loss aversion) or take excessive risks to recover losses (risk-seeking in the loss domain).