Statement 2: (from a client): “When considering investments, I have always liked using long option positions. I like their risk/return tradeoffs. My personal estimates of the probability of gains seem to be higher than those implied by the market prices. I am not sure how to explain that, but to me, long options provide tremendous upside potential with little risk, given the low probability of limited losses.”
Answer: Statement 2 is consistent with prospect theory; the client is overweighting the probability of a high financial impact outcome (gains on options) and underweighting the probability of a loss (the option premium cost).
In my understanding, Option is low risk, high payoff risk, and investor is risk-seeking for gain. However, prospect theory demonstrates risk-seeking for loss.
Please someone help me understand it, thank you so much.