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Managing Option Trading Risk with Greeks when Analogy Making Matters

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  • Siddiqi, Hammad

Abstract

There are various types of risk associated with trading options. Traders typically manage such risks with the help of various partial derivatives of option prices known as Greeks. Experimental and anecdotal evidence suggests that mental accounting matters in the valuation of options. Mental accounting changes the values of Greeks significantly with crucial implications for risk management. I show that for a call option, delta-risk is under-estimated, gamma risk is over-estimated, and the value-decay due to the passage of time is under-estimated. For a put option, all three types of risks are over-estimated. I also show that covered call writing is more profitable when mental accounting influences prices.

Suggested Citation

  • Siddiqi, Hammad, 2013. "Managing Option Trading Risk with Greeks when Analogy Making Matters," Risk and Sustainable Management Group Working Papers 160607, University of Queensland, School of Economics.
    • Handle: RePEc:ags:uqsers:160607
    DOI: 10.22004/ag.econ.160607
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    References listed on IDEAS

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    1. Bookstaber, Richard & Clarke, Roger, 1984. "Option Portfolio Strategies: Measurement and Evaluation," The Journal of Business, University of Chicago Press, vol. 57(4), pages 469-492, October.
    2. George M. Constantinides & Michal Czerwonko & Jens Carsten Jackwerth & Stylianos Perrakis, 2011. "Are Options on Index Futures Profitable for Risk‐Averse Investors? Empirical Evidence," Journal of Finance, American Finance Association, vol. 66(4), pages 1407-1437, August.
    3. Merton, Robert C & Scholes, Myron S & Gladstein, Mathew L, 1978. "The Returns and Risk of Alternative Call Option Portfolio Investment Strategies," The Journal of Business, University of Chicago Press, vol. 51(2), pages 183-242, April.
    4. Siddiqi, Hammad, 2012. "The relevance of thinking-by-analogy for investors’ willingness-to-pay: An experimental study," Journal of Economic Psychology, Elsevier, vol. 33(1), pages 19-29.
    5. Siddiqi, Hammad, 2013. "Mental Accounting: A Closed-Form Alternative to the Black Scholes Model," MPRA Paper 50759, University Library of Munich, Germany.
    6. Bernard Morard & Ahmed Naciri, 1990. "Options and investment strategies," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 10(5), pages 505-517, October.
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