How trading shocks shape risk preferences: nonlinear evidence from retail forex traders

Purpose
This paper addresses the conflicting views on whether traders become more risk-averse or more risk-seeking after experiencing trading shocks. It aims to uncover how the magnitude of prior gains or losses influences subsequent risk-taking behavior in retail trading.

Design/methodology/approach
Using over 349,000 daily retail trading records, the study classifies trading shocks into 18 levels and examines their lagged effects on traders' risk-taking behavior, measured by leverage.

Findings
Traders' responses to prior shocks exhibit clear asymmetry. After small shocks, whether gains or losses, traders become more risk-averse. In contrast, after large shocks, especially gains, they become increasingly risk-seeking. These effects scale with shock levels and fade over time. The switching point between risk aversion and risk seeking lies deeper in the loss domain.

Practical implications
By revealing nonlinear post-shock risk preferences, this study suggests design opportunities for trading platforms, such as nudging tools to prevent excessive risk-taking after large shocks. It also informs risk management systems that aim to reduce over-leverage during volatile periods.

Originality/value
This paper introduces a detailed framework for analyzing aftershock risk preferences, offering a behavioral explanation for previous mixed findings. It contributes to the literature by revealing a nonlinear, asymmetric pattern in how risk preferences respond to shocks.