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I've heard that option market makers make their bid ask spread as wide as the vega of the contract they are quoting. If the quoted spread is narrower than the vega of the option it is said that the price is competitive. Why is this? What is the basis for the rule of thumb?

So for example, if the at the money option has A vega of 10 the corrosponding market could be 1.10 bid 1.20 ask (it is 10 cents wide).

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The reason vega is used like this in quoting a spread is two fold. First, vega gives the change in price with respect to a change in volatility. So when you obtain a bid ask volatility you can multiply by vega to get the bid ask in dollars. It is as if you are pricing two different options, one with a lower vol and one with a higher vol.

The second reason is intuitively obvious. The spread is made wider for options whose prices have higher variation. So options need to have a corresponding spread in dollar terms to account for this risk.

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  • $\begingroup$ OK. Something I don't understand: Vega is the price respone to a 1 percentage point increase in vol. But why are we considering a 1% increase, why not 2% (two vegas) or 3%. That's what I don't understand. That the spread be proportional to vega makes sense, but why the coefficient is 1? $\endgroup$ – Alex C Oct 16 '19 at 20:16
  • $\begingroup$ I suppose you could make the spread proportional to two or three etc vegas. I think the point is just that to ensure consistent spreads/pricing across contracts, all the spreads should be proportional to vega in the same way? So say you decide you are making 2 vega wide markets on the ATM call with 10 vega (20 points wide) then when you give a price for an OTM option with 5 vega your market should be 10 points wide. What do you think? $\endgroup$ – roz Oct 17 '19 at 14:29

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