SSRN-Coarse Thinking, Implied Volatility, and the Price of Call and Put Options by Hammad Siddiqi

SSRN-Coarse Thinking, Implied Volatility, and the Price of Call and Put Options by Hammad Siddiqi:

"We derive a new option pricing formula based on the notion that the market consists of coarse thinkers as well as rational investors. The new formula, called the behavioral option pricing formula is a generalization of the Black-Scholes formula. The new formula not only provides explanations for the implied volatility skew and term structure puzzles in equity index options but is also consistent with the observed negative relationship between contemporaneous equity price shocks and implied volatility."

In their words:

" Given undeniable evidence of the role of coarse thinking in almost everything we do, what are the implications for options pricing if some investors are coarse thinkers? Intuitively, an in-the-money call option is similar to its underlying stock. So rather than investing in the underlying outright, some investors prefer to buy an in-the- money call option, as an in-the-money call offers the same dollar-for-dollar increase or decrease in payoff as the underlying while requiring only a fraction of investment. However, this advantage comes at a cost. An in-the-money call is riskier than the underlying...."

Interesting.

Cite: Siddiqi, Hammad, Coarse Thinking, Implied Volatility, and the Price of Call and Put Options (January 8, 2010). Available at SSRN: http://ssrn.com/abstract=1636247