Volatility Skew and Smile Trading
Peter Carr recently gave a talk on volatility trading at the Fields institute.
In general, an option’s fair value depends crucially on the volatility of its underlying asset. In a stochastic volatility (SV) setting, an at-the-money straddle can be dynamically traded to proﬁt on average from the diﬀerence between its underlying’s instantaneous variance rate and its Black Merton Scholes (BMS) implied variance rate. In SV models, an option’s fair value also depends on the covariation rate between returns and volatility. We show that a pair of out-of-the-money options can be dynamically traded to proﬁt on average from the diﬀerence between this instantaneous covariation rate and half the slope of a BMS implied variance curve. Finally, in SV models, an option’s fair value also depends on the variance rate of volatility. We show that an option triple can be dynamically traded to proﬁt on average from the diﬀerence between this instantaneous variance rate and a convexity measure of the BMS implied variance curve. Our results yield precise ﬁnancial interpretations of particular measures of the level, slope, and curvature of a BMS implied variance curve. These interpretations help explain standard quotation conventions found in the over-the counter market for options written on precious metals and on foreign exchange.
In this talk, Carr discussed which options you should trade when
Click here to watch
Article Source Here: Volatility, Skew, and Smile Trading
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