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Options Strategy – Volatility Surface

Video Tutorial

Premise: Volatility Surface, what it is and what it is used for

Each option is exchanged on the trading book where it has a price that is mainly exposed by the Market Maker (MM) which is the institution in charge of quoting the instruments that are not very liquid.

The price of the option depends on the following factors:

  • Style: European or American;
  • Series: call or put;
  • Strike: activation value of the option;
  • Expiration Date: the date on which the option expires;
  • Underlying Price: last value of the underlying at the moment;
  • Risk Free Rate: the prime interest rate (6-month Euribor).

which are objective since they will have the same value in the financial world at the same time.

But if you try to compose the price of an option with the calculator (Options Evaluator) you will find that the value of the option remains at 0 until a value is introduced in the Implied Volatility field: the risk value received by the Market Maker which prefers the option.

And always varying this value you will find that the price of the option varies significantly.

Well, that value is entered into the formula in an arbitrary manner by the Market Maker which, as in all markets, must seek a compromise between its expectations and those of the customer. The MM will enter a much higher implicit volatility the more it will consider that the option it is quoting is risky.

So, if we extract the value that the MM imputes for each strike on a single expiry and place it in a Cartesian plan, where the value is on the “Y” axis and the corresponding strike value is on the “X” axis we will get, joining the points of each single value, a smile or a skew.

At this point we can imagine that if we wanted to represent the risk value of all the options listed on all the strikes and on all the expiries, the representation would be a smile next to the next one, or we will get a surface.

That is the surface of implied volatility.

What it takes to:

  • have a theoretical option price in the phases in which the market is closed and you want to make strategic evaluations using the appropriate What-IF tool (what … if);
  • verify that the strategic plans it has implemented are valid by testing them in the Planning section;
  • perform studies based on the hypothesis that knowing the price of risk we can imagine the area or the deadline considered more risky by the MM. A simple example: if the Call options have a higher risk than the Put it will mean a forecast of a strong climb priced by the MM;

Understanding the Volatility Surface feature

The Volatility Surface tool allows you to acquire and modify the volatility surfaces on which the theoretical prices of the options that are used both for the strike prices deep otm or deep itm (which are often not listed on the market) are calculated, and for the use of beeTrader outside of market sessions. This allows us to study our strategies both in open market and closed market with the use of a very sensitive and reliable theoretical pricing system.

At start-up the last surface associated with the underlying is displayed, so at the first start on a new one below the surface will be empty; in this case there are three possibilities: acquire the surface from the market, load a saved surface, or use a surface from the predefined ones that are supplied with the beeTrader installation.

Surface acquisition

1. The starting surface

2. Choice of the expiries to be acquired

3. Download data from the broker

4. The new surface

  1. When the Volatility Surface function is started, the last volatility surface acquired for the underlying is displayed, it follows that if no one has ever been acquired, the surface will be flat with the historical volatility of the underlying;
  2. When the acquisition is started, the window for choosing the expiry date to request from the broker appears. It is necessary to acquire at least three deadlines. The number of expiries (over 3) and strikes are the user’s choice, the more expiries and strikes are incorporated into the surface the more it will be reliable for subsequent calculations; however a high number of requests makes the procedure rather slow. A minimum reliable number is 3 strikes for 16 strikes, having the foresight to choose at least two quarterly maturities;
  3. Choosing deadlines beeTrader starts requesting data from the broker. The number of required and received strikes is displayed; the percentage should be around 70% -80% to be reliable. If the percentage is lower it means that many strikes are not quoted, this can happen with underlyings not very traded on long expiries;
  4. At the end the processed area appears starting from the received data.

Surface modification

Click on the image to expand

By clicking on the Edit Surface button it is possible to modify the surface by acting on each curve that composes it (therefore expiry by expiry). The menu includes the commands to raise or lower the entire curve, or you can act strike to strike with the left click of the mouse to raise that specific point and with the right click to raise it.

Once the modification is finished and the Edit Surface window is closed, the Volatility Surface window shows the surface before the modification and the one after the modification, through the Apply button the surface modification is confirmed.