Options: How They're Used, How They're Priced, and How They Reflect Sentiment

Hersh Shefrin

in Beyond Greed and Fear

Published in print October 2002 | ISBN: 9780195161212
Published online November 2003 | e-ISBN: 9780199832996 | DOI:

Series: Financial Management Association Survey and Synthesis Series

 Options: How They're Used, How They're Priced, and How They Reflect Sentiment

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Option markets reflect all three behavioral themes. The chapter is organized around the way options are (1) used; (2) priced; and (3) reflect investor sentiment. The chapter begins with the popular ways investors use options, where frame dependence figures prominently. The focus is on covered call writing, but also discusses how employees make decisions about exercising company stock options. In discussing pricing, the discussion emphasizes the relationship between investors' expectations about future volatility, so called “implied volatility,” and actual volatility. The point here is that heuristic‐driven bias moves implied volatility away from its objective counterpart. In other words, heuristic‐driven bias causes option markets to be inefficient. The chapter discusses two related phenomena that stem from the effect the 1987 stock market crash had on implied volatility. One is known as “crashophobia,” and the other is known as the “crash premium.” The chapter ends with a discussion about the influence investor sentiment has had on patterns of option trading.

Keywords: covered call writing; crash premium; crashophobia; employee stock options; framing; mental accounts; opaqueness; optimism; pessimism; representativeness; sentiment; transparency; volatility

Chapter.  5512 words.  Illustrated.

Subjects: Financial Markets

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