This paper examines the profitability and risk-taking behavior of individual traders on the Taiwan Futures Exchange (TAIFEX) by tracking their trade-by-trade transaction histories. We show that although as a group individual traders have a net loss after all transaction costs, there are fairly profitable traders, accounting for about 1/3 of the traders. That is, we show that as many as 1/3 of individual futures traders are profitable—actually with higher median profits in magnitude than unprofitable traders—when we examine each of them separately. Further examination reveals that profitability varies systematically with trading frequency and volume. Focusing on the frequent and high-volume traders and following their trades as they steadily accumulate then offset contract positions, we analyze their risk-taking behavior by examining how they respond after reaching some threshold levels of losses and gains. We investigate whether they vary in their responses and link the variations to their profitability. We show that in aggregate they tend to reduce risk and offset their trades after reaching some threshold levels of losses and gains. However, the risk-reducing tendency varies in a systematic fashion, which in turn affects their profitability differently depending on whether they are profitable or not. On the one hand, among profitable traders, those who take risk to continue accumulate more positions in the face of threshold losses and gains are more profitable. On the other hand, among unprofitable traders, those who tend to reduce risk by offsetting their positions when faced with the threshold losses and gains suffer smaller losses. In contrast to the evidence from previous studies that examine the aggregate trader, the results from this study shed new light on the general conclusions on the profitability and overconfidence in the literature. From traders’ standpoint, the evidence of a linkage between profitability and risk-taking in trading also has practical implications for trading strategies.

Annaert, Jan, Dries Heyman, Michele Vanmaele, and Sofieke Van Osselaer, 2008, Disposition bias and overconfidence in institutional trades, Working Paper , Financial Management Association International (FMA) Annual Meeting, Available at http://www.fma.org/Texas/TexasProgram.htm.

Barber, Brad M., Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean, 2007, Is the Aggregate Investor Reluctant to Realize Losses? Evidence from Taiwan, European Financial Management 13, 423-447.

Barber, Brad M., Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean, 2009, Just How Much Do Investor Lose by Trading? Review of Financial Studies 22, 609-632.

Barber, Brad M., and Terrance Odean, 2000, Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, Journal of Finance 55, 773-806.

Barber, Brad M., and Terrance Odean, 2001, Boys will Be Boys: Gender, Overconfidence, and Common Stock Investment, Quarterly Journal of Economics 116, 261-292.

Chen, Gong-Meng, Kenneth A. Kim, John R. Nofsinger, and Oliver M. Rui, 2007, Trading Performance, Disposition Effect, Overconfidence, Representativeness Bias, and Experience of Emerging Market Investors, Journal of Behavioral Decision Making 20, 425-451.

Cheng, Teng Yuan, Chun I Lee, Chao Hsien Lin, and Hung Chih Li, 2009, A Direct Test of the Link between the Disposition Effect and Profitability in Futures Market, Working paper, European Financial Management Association (EFMA) 2009 Annual Meeting, Available at http://www.efmaefm.org/.

De Bont, W., and R. Thaler, 1995, Financial Decision-Making in Markets and Firms: A Behavioral Perspective, in R. Jarrow, V. Maksimovic W. Ziemba (eds.), Handbooks in Operations Research and Management Science, Vol 9: Finance (Elsevier Press), 385–410.

De Long, J. Bradford, A. Shleifer, Lawrence H. Summers, and Robert J. Waldmann, 1990, Noise trader risk in financial markets, Journal of Political Economy 98, 703-738.

Dhar, Ravi, and Ning Zhu, 2006, Up Close and Personal: Investor Sophistication and the Disposition Effect, Management Science 52, 726-740.

Frino, Alex, David Johnstone, and Hui Zheng, 2004, The propensity for local traders in future markets to ride losses: Evidence of irrational or rational behavior, Journal of Banking & Finance 28, 353-372.

Frino, Alex, Joel Grant, and David Johnston, 2008, The house money effect and local traders on the Sydney Futures Exchange, Pacific-Basin Finance Journal 16, 8-25.

Garvey, Ryan, and Anthony Murphy, 2004, Are Professional Traders Too Slow to Realize Their Losses? Financial Analyst Journal, 60, 35-43.

Garvey, Ryan, Anthony Murphy, and Fei Wu, 2006, Do Losses Linger? Journal of Portfolio Management, 75-83.

Genesove, David, and Chris Mayer, 2001, Nominal loss aversion and seller behavior: Evidence from the housing market, Quarterly Journal of Economics 116, 1233-1260.

Gervais, Simon, and Terrance Odean, 2001, Learning to be overconfident, The Review of Financial Studies, 14, 1-27

Glaser, Markus, and Martin Weber, 2007, Overconfidence and trading volume, The Geneva Risk and Insurance Review 32, 1-36.

Goetzmann, William N., and Alok Kumar, 2005, Why Do Individual Investors Hold Under-Diversified Portfolios? Available at SSRN: http://ssrn.com/abstract=627321.

Grinblatt, Mark, and Matti Keloharju, 2000, The Investment Behavior and Performance of Various Investor Types: A Study of Finland’s Unique Data Set, Journal of Financial Economics 55, 43-68.

Harris, Jeffrey H., and Paul Schultz, 1998, The trading profits of SOES bandits, Journal of Financial Economics 50, 39-62.

Heath, Chip, Steven Huddart, and Mark Lang, 1999, Psychological factors and stock option exercise, Quarterly Journal of Economics 114, 601-627.

Heisler, Jeffrey, 1994, Loss Aversion in Futures Markets: An Empirical Test, The Review of Futures Markets, 13, 793-822.

Ivkovich, Zoran, Clemens Sialm, and Scott J. Weisbenner, 2007, Portfolio concentration and the Performance of Individual Investors, Journal of Financial and Quantitative Analysis 43, 613-655.

Ivkovich, Zoran, and Scott J. Weisbenner, 2005, Local Does as Local Is: Information Content of the Geography of Individual Investors’ Common Stock Investments, Journal of Finance 60, 267-306.

Kahneman, D., and A., Tversky, 1979, Prospect theory: An analysis of decision under risk, Econometrica 47, 263-291.

Kyle, Albert S, and F. Albert Wang, 1997, Speculation duopoly with agreement to disagree: Can overconfidence survive the market test? Journal of Finance 52, 2073-2090.

Linnainmaa, Juhani, 2003a, The Anatomy of Day Traders, Available at SSRN:
http://ssrn.com/abstract=472182

Linnainmaa, Juhani, 2003b, Who Makes the Limit Order Book? Implications for Contrarian Strategies, Attention-Grabbing Hypothesis, and the Disposition Effect, Available at SSRN: http://ssrn.com/abstract=474222.

Liu, Yu-Jane, Chih-Ling Tsai, Ming-Chun Wang, and Ning Zhu, 2006, House Money Effect: Evidence from Market Makers at Taiwan Futures Exchange, Available at SSRN: http://ssrn.com/abstract=891564.

Locke, P., and S. Mann, 2005, Do professional traders exhibit loss aversion, Journal of Financial Economics 76, 401-444.

Odean, Terrance, 1998, Are investors reluctant to realize their losses? Journal of finance 53, 1775-1798.

Odean, Terrance, 1999, Do Investors Trade too Much? American Economic Review 89, 1279-1298.

Ricciardi, Victor, 2008, The Psychology Of Risk: The Behavioral Finance Perspective. Handbook Of Finance: Volume 2: Investment Management And Financial Management, Frank J. Fabozzi, Ed., John Wiley & Sons, 85-111.

Sandroni, A., 2005, Efficient markets and Bayes’ rule, Economic Theory 26, 714–764.

Schlarbaum, Gary G., Wilbur G. Lewellen, and Ronald C. Lease, 1978a, The Common-Stock-Portfolio Performance Record of Individual Investors: 1964-70, Journal of Finance, 33, 429-441.

Schlarbaum, Gary G., Wilbur G. Lewellen, and Ronald C. Lease, 1978b, Realized Returns on Common Stock Investments: The Experience of Individual Investors, Journal of Business, 51, 299-325.

Shefrin, H and M. Statman, 1985, The Disposition to Sell Winners Too Early and Ride Losers Too Long : Theory and Evidence, Journal of Finance 40, 777-790.

Statman, M., S. Thorley, and K. Vorkink, 2006, Investor overconfidence and trading value, The Review of Financial Studies 19, 1531-1565.

Thaler, R., 1985, Mental Accounting and Consumer Choice, Marketing Science 4, 199–214.

Thaler, R., and E. Johnson, 1990, Gambling with the House Money and Trying to Break
Even: The Effects of Prior Outcomes on Risky Choice. Management Science, 36, 643-660.

Wang, F., 2001, Overconfidence, investor sentiment and evolution, Journal of Financial Intermediation 10, 138～170.