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I fail to see what time to expiration of an option has to do with the SV
of the underlying, or vice versa. The IV of an option is a guess for the future.
The SV of the underlying is a fact of the past. What sense does it make
for a MM to use the most recent 30 day SV for pricing an option that expires
30 days in the future? What sense does it make to use 1 yr SV to price an
option that expires a year from now? Perhaps there is the assumption that
the 30 day volatility would continue for the next 30 days? I would challenge
that assumption (see below).
I have pointed out in a previous post that certain movements of the underlying
do not show up in the SV calcs that are being used by option pricing models.
This is true whether those market movements occur in the most recent 30 day
period or a 30 day period that occured 6 months ago. It can vary considerably.
There is an edge to be gained from the correct forecasting of volatility.
Many believe that volatility can be predicted better than price action, particularly the return to the mean of volatility.
Let's assume that the most recent 30 days shows an extreme abnormal activity
in a certain stock. One would expect then that a return to normal volatility
would characterize the next 30 days in the future. Therefore it makes no sense
to me that a trader, much less a MM, would use the previous 30 days SV in forecasting the option price 30 days from now. MMs engaging in such a practice could seriously misprice their options. It is better in my mind to use
the 1 year SV for pricing 30 day options. It wouldn't matter if the 30 day
and the 1 year are close together, but when the 30 day volatility is twice the
1 year, I would expect a return to the mean rather than a continued abnormality.
Neal
Ira wrote:
>You have what I said correctly. MM usually use time to expiration as the time for >volatility calcs. The reason is that most of them have large ratio write >positions, unless things have changed over the years.
----- Original Message -----
From: sire@xxxxxxx
To: realtraders@xxxxxxxxxxxxxxx
Sent: Monday, February 16, 2004 5:56 PM
Subject: Re: [RT] Calendar Spreads
Ira,
Thinking about your post on volatility leaves me
somewhat confused again.
You talk about the volatility of the underlying,
but the underlying has only one kind of volatility - statistical,
so are you saying that one trader might use the SV of the last
30 days, while another would use SV of the last year?
So are we talking about traders with differing specific purposes
using different SV of the underlying to get a price for an option,
which may vary considerably from the price given to the option by MMs?
It would also help to know what period SV is being used by the MMs.
Neal
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