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Anchoring Heuristic in Option Prices

Siddiqi, Hammad (2014): Anchoring Heuristic in Option Prices.

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Abstract

An anchoring-adjusted option pricing model is developed in which the expected return of the underlying stock is used as a starting point that gets adjusted upwards to form expectations about corresponding call option returns. Anchoring bias implies that such adjustments are insufficient. In continuous time, the anchoring price always lies within the bounds implied by expected utility maximization when there are proportional transaction costs. Hence, an expected utility maximizer may not gain utility by trading against the anchoring prone investors. The anchoring model is consistent with key features in option prices such as implied volatility skew, superior historical performance of covered call writing, inferior performance of zero-beta straddles, smaller than expected call option returns, and large magnitude negative put returns. The model is also consistent with the puzzling patterns in leverage adjusted option returns, and extends easily to jump-diffusion and stochastic-volatility approaches.

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