Managing option-trading risk when mental accounting influences prices

Carolyn Moclair

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Framing of assets into mental accounts affects how they are perceived and priced.
A call option is often framed in the same mental account as the underlying stock.
This changes the values of the Option Greeks that are crucial for risk management.
Formulas for Option Greeks adjusted for mental accounting are put forward.

Abstract

ABSTRACT

The experimental evidence and opinions of market professionals suggest that mental accounting influences option prices. This paper explores the implications for risk management of mental accounting of a call option with its underlying. If mental accounting influences prices and the Black-Scholes approach is used, then, for in-the-money call options, delta risk is underestimated, gamma risk is overestimated and the extent of the time decay is underestimated. Covered-call writing is significantly more profitable with mental accounting than without it. Formulas for Greeks adjusted for mental accounting are put forward.

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