Managing Option Trading Risk when Mental Accounting Influences Prices
27 Pages Posted: 12 Jan 2014 Last revised: 10 Jun 2016
Date Written: November 24, 2013
Experimental evidence and opinions of market professionals suggest that mental accounting influences option prices. I explore the implications of mental accounting of a call option with its underlying for risk management. If mental accounting influences prices and the Black Scholes approach is used, then for in-the-money call options, delta-risk is under-estimated, gamma-risk is over-estimated, and the extent of time decay is under-estimated. Covered call writing is significantly more profitable with mental accounting than without it. Formulas for Greeks adjusted for mental accounting are put forward.
Keywords: Mental Accounting, Greeks, Options, Delta, Gamma, Theta, Covered Call
JEL Classification: G13, G12
Suggested Citation: Suggested Citation