I'm attempting to fit a curve through moneyness/IV datapoints of intra-day options. As you can see, the data gets sparser and more variable for highly OTM options. vertical axis: IV, horizontal: moneyness

I'd like to argue why the outliers in this case can be (at least partially) ignored. One topic-independent argument would be simply the sparsity of the data, giving the outliers exaggerated importance. I would like to make a stronger argument with connection to options though.

My reasoning, from what I gathered through a little research, is something along the lines of: the OTM options are by their nature more likely to create anomalies like this since they are very risky and likely to be traded by amateurs who are attracted by low option premiums. Thus an outlier is less likely to hold valuable information about the market. Whether that makes (any) sense and whether that could create this effect in the IV is not something I can decide with my lack of theoretical and empirical knowledge about this topic.

Am I at least somewhat correct? What would be a correct argument? Is there some literature backing up the statements?

It's entirely possible I'm missing something or am completely wrong. If that's the case, is there an argument to be made to the same effect?

Please answer in simple terms. I am a student of mathematics so I can deal with mathematical complexity, but have very little knowledge of financial derivatives.

Thank you very much!

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    $\begingroup$ One argument I like is that the value of options is determined by the way one models the underlying. The underlying's price at the option Expiry has some unknown probability distribution, where various people model it differently. These models are going to agree the most around the fwd price, as it has the highest probability - if the model were wrong in the most likely area its obviously a bad model. The wings are somewhat less important, since it is a less likely area to end up in - a difference here will have less effect. Perhaps that contributes. $\endgroup$ – will Jul 19 '16 at 22:25
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    $\begingroup$ It's also worth mentioning that on the other end of the spectrum (far ITM), the model assumptions matter less and less (since it's almost only intrinsic value), so you would not observe such a behaviour, even with a low liquidity. But obviously using intraday data will bring in some noise. Are you using bid/ask data? Because you still have weird stuff going on at the money $\endgroup$ – Quantuple Jul 20 '16 at 15:56
  • $\begingroup$ @Quantuple You know, I am not sure, I got very little information on the data I have. What would that mean if I did? $\endgroup$ – Dahn Jul 20 '16 at 21:12
  • $\begingroup$ Well that you could have a bid/ask IV spread for each listed strke instead of a single value and that this spread should be tighter close to the money (more actively traded contracts) $\endgroup$ – Quantuple Jul 20 '16 at 21:58

This is a qualitative answer... Deep otm options have a value associated with there degree of convexity.. it has a much higher rate of change then anything ATM... Gamma is explosive for expiring otm options... Otm options also represent the rare event of a higher order.. so a deep otm option represents a tail event basically... we don't know much about tail events just that they have power laws to them .. nothing about their frequency... So basically you would have to make enough money selling those deep otm premiums to cover the loss when the rare event blows through your strike... Because a very small amount of money can hedge a very large drop in a portfolio the premium demand is higher as well.. I've been told this happened after 87 crash... It has to do with convex asymmetric payoffs basically... It's the first thing you learn when trading otm options typically by losing money

  • $\begingroup$ Thank you for your answer. Could you comment on how this relates to the IV value of the options? $\endgroup$ – Dahn Jul 20 '16 at 21:15
  • $\begingroup$ Sorry I don't understand your question... Are you asking about skew? $\endgroup$ – cdcaveman Jul 20 '16 at 21:41
  • $\begingroup$ Well I'd like to argue that the single value around the 0.83 moneyness level is very likely not important and can be ignored. For that I'd like to argue that OTM options are more likely to create such outliers. (Of course, that may not be true, which is why I am asking) $\endgroup$ – Dahn Jul 20 '16 at 21:45
  • $\begingroup$ Typically you talk about things in the reverse... Your talking about a 20 Delta otm option... And your searching for causation is futile ... That is ever changing and won't have to do with otm options... Sure if a large seller of deep otm puts gets liquidated you could see an outsize move in the underlying... But that won't likely be the cause all the time nor will you know when it is untill after the fact.. you should read more about skew and fat tails... $\endgroup$ – cdcaveman Jul 20 '16 at 21:56
  • $\begingroup$ Any suggestion on what should I read? I understand that I am lacking in knowledge a lot. To make sure: therefore it would be wrong to attempt to make a link between OTM and the likelyhood of observing outliers in the IV values? $\endgroup$ – Dahn Jul 20 '16 at 22:05

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