Saturday, July 2, 2011

basic quote filtering during vol inversion

* large bid/ask spread may be filtered out, if there are more than 10 data points on a smile curve.

* low vega (10e-6) bid/ask quotes are discarded. Here's why --

After an option premium quote (in dollars) is converted using BS, vega is easily compouted by BS. Low vega often indicates low liquidity, less demand, less traded.

Implied volatility inversion is a numerical procedure with a defined tolerance. For a given tolerance (i'm guessing 10e-8 or 10e-14 or whatever), the low-vega quote would have a large inherent "tolerance/inaccuracy/tolerance" in the implied vol. As a result, the implied vol is less reliable in this particular option quote. A quant told me a small noise in present value can lead to big noise in implied vol. The low vega is a magnifying lense.

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