Sunday, July 8, 2012

##conventional wisedoms in option valuation

There are many empirical rules in option math, but I feel with different universality and reliability.

Rule) vega of an ATM op =~ premium / implied vol
Rule) put-call equivalence in FX options. See separate blog post http://bigblog.tanbin.com/2011/11/equivalent-option-positions.html
Rule) PCP - "complicated" in American style, according to CFA textbook
Rule) delta(call) + delta(put) =~ 100% -- See separate blog post http://bigblog.tanbin.com/2010/06/delta-of-call-vs-put.html
Rule) delta is usually between 0 and 1? Someone told me it can exceed 1 before ex-div
Rule) option valuation always decays with time
Rule) ATM delta is "very close" to 50%, regardless of expiration
Rule) delta converges with increasing vol. See separate blog post http://bigblog.tanbin.com/2011/11/option-rule-delta-converges-to-5050.html

Rule) For a strike away from predicted forward price, the OTM option has better liquidity than the ITM option. Therefore the OTM is  more useful/important to volatility estimate at that strike.

Rule) for equities, OTM put quotes show higher i-vol than OTM calls. Incidentally, at the same low strike, the OTM put is more liquid than ITM call. Reason is, most people trade OTM options only. However, ITM options are still actively traded -- if an ITM option is offered at a low enough price, someone will buy; if an OTM option is bidding high enough, someone will write the option.

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New York (Time Square), NY, United States
http://www.linkedin.com/in/tanbin