Anchoring and Adjustment Heuristic in Option Pricing
34 Pages Posted: 30 Dec 2015 Last revised: 19 May 2017
Date Written: October 30, 2016
A common reasoning process is to rely on an informative starting point which is somewhat incorrect and then attempt to adjust it appropriately. Evidence suggests that underlying stock volatility is such a starting point, which is scaled-up to estimate call option volatility. I adjust Black-Scholes, Heston, and Bates option pricing models for reliance on this starting point. Adjusted Black-Scholes explains implied-volatility skew and other puzzles. Adjusted Heston stochastic volatility model matches the same data better, does so at more plausible values, while generating a steep short term skew. Furthermore, two novel predictions are empirically tested and are strongly supported in the data.
Keywords: Anchoring, Implied Volatility Skew, Covered Call Writing, Zero-Beta Straddle, Leverage Adjusted Option Returns
JEL Classification: G13, G12, G02
Suggested Citation: Suggested Citation