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I am analysing option-implied RNDs and risk preferences for my masters thesis, so forgive me if I sound like a beginner in derivatives.

I use WRDS to download my historic options data. I am looking at SPX European Friday-settlement options with τ = 5 weeks, looking at a month by month nonoverlapping data. I'll give an example:

Information Date: Dec 13th, 2017

Exercise Date: Jan 19th, 2018

Index Close: 2662.85

Strike: 1000

Average of bid and ask for this strike: 1663.50

Volume: 250

Implied vol: 1.3931

The next available strike with volume > 0 was K = 2000, with strikes above having reasonable gaps and volumes. This is not the only dataset where I see this. Is this normal and is it okay to include it in the dataset to build the RND? I assume the answer will be related to trading fees, but just want someone with more knowledge to confirm.

Thanks.

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  • $\begingroup$ As you can see when a Call is this deep in the money the Implied Vol is not reliable. So I would not use it. But a bigger question is WHY people trade such an option. And that I don't know. $\endgroup$ – noob2 Aug 17 '20 at 16:23
  • $\begingroup$ I’m just guessing but does it have anything to do with var swap hedging/replication? $\endgroup$ – oronimbus Aug 17 '20 at 18:53
  • $\begingroup$ oronimbus: trading deep ITM call for tail hedge seems to be very unlikely $\endgroup$ – CABLE Aug 18 '20 at 5:41
  • $\begingroup$ thank you everyone $\endgroup$ – br0323 Aug 18 '20 at 9:38
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I'm also currently working on analyzing option-implied RNDs. I'm no expert but a couple of comments:

  • In addition to volume, you want to look at the open interest of the different strikes to conclude which prices are reasonable.
  • Humans like round numbers so especially for deep OTM strikes you will see the bulk of open interest located at nice numbers.
  • Deep OTM options tend to be more liquid than deep ITM options so when constructing the vol smile for the RNDs, you can use OTM call and OTM put IVs.
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Was the put of that strike also traded? If yes, then maybe somebody entered a box position to lock in the risk-free rate. If no, I don't know...

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