Managing option-trading risk when mental accounting influences prices

Hammad Siddiqi

Journal of Risk

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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