Managing Option Trading Risk when Mental Accounting Influences Prices

Abstract

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.