Managing Option Trading Risk with Greeks when Analogy Making Matters
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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.