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From: Scott Krause
Affiliation:
Address:
Date: 06 Jul 2004
Time: 01:43:15
I recently took a course from an options market maker/hedge fund manager in which we discussed the implied volatility smile. He made an interesting point about some anomalies in the implied volatility smile that “should not” be included when making the calculations.
He said that all options have two factors that effect implied volatility calculations that can create incorrect implied volatilities.
1. Listed options trade in .05 increments and are market in .05 steps. When solving for implied volatility from the market, close, bid, or offer on out-of-the-money options in many cases create a larger or smaller skew, depending on option price and underling price.
2. The second is even a greater problem. All listed options have to have a price and closing price. Out-of-the-money options that are no bid at .05 or no bid at .10 will still have an implied volatility, since we are solving for implied from a listed price. The option’s implied volatility will increase the further the out-of-the-money they are and the closer to expiration. He mentioned that we should not include them when calculating the implied volatility, since they don’t trade, but have to be given a price ( 0 - .05). He mentioned that this is even a greater problem in indexes with the standard out-of-the-money options are no bid at .25 or at .50, which can greatly skew the implied.
Two saying he always made were “Theta kicks Implied’s butt in the end!” I think that he meant that no matter how high we took the implied volatility, since it only affects the extrinsic value of options, that in the end they decay to zero.
The other saying was “Volatility wise, dollar foolish!” He mentioned several market makers trading the skew and hedging delta neutral. The problem was that they would buy or sell out-of-the-money options and hedge them with stock, but these options were only .05 or .10 and that they were not volatility at all, but just a cheap option. He mentioned that most market makers hedging these positions delta neutral ended up blowing out in the end.
I found this topic very interesting and how experience in the real world of trading vs. the theoretical world of understanding makes a huge difference in success and failure.
My question is this:
At what point do I stop giving implied volatility weighting to the out-of-the-money options?
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