Vol Smile is making me frown

D

drenaud

I am trying to calculate 'fair value' using the BSM on the ES.

I get it that we don't have all the inputs. We have to guess at the vol. I have seen some people suggest that if you are trading an option that has 60 days to expiration you could use the last 60 days vol as a possible input. (guess)

What has me twisted up is how to apply that to an option that is 50 points away from the current price? I see the implied vol goes from about 20 to 50 very quickly as you chose an option away from the current price. I believe this is this is the vol smile.

So if I want to calculate an estimated value for an option this is 25,50, or 100 points away from the current price how can I get a reasonable vol estimate to plug in?


Thanks for any ideas.

David
 
Quote from drenaud:
----I am trying to calculate 'fair value' using the BSM on the ES.
----if I want to calculate an estimated value for an option that is 25, 50, or 100 points away from the current price how can I get a reasonable vol estimate to plug in?
More...
?....Use the option values from similar strike prices in the SPY and SPX. :confused:
 
Quote from drenaud:

I am trying to calculate 'fair value' using the BSM on the ES.

I get it that we don't have all the inputs. We have to guess at the vol. I have seen some people suggest that if you are trading an option that has 60 days to expiration you could use the last 60 days vol as a possible input. (guess)

What has me twisted up is how to apply that to an option that is 50 points away from the current price? I see the implied vol goes from about 20 to 50 very quickly as you chose an option away from the current price. I believe this is this is the vol smile.

So if I want to calculate an estimated value for an option this is 25,50, or 100 points away from the current price how can I get a reasonable vol estimate to plug in?


Thanks for any ideas.

David
More...

As you have correctly pointed out, getting the right volatility input is the key to getting a meaningful theoretical fair value. Unfortunately, that's the "$1mil question".
 
Is there some formula or adjustment that can be made to 'convert' ATM implied vol to out of the money implied?

That is if implied ATM is 20% then a call 10% higher should have an implied of X%? Basically accounting for the vol smile.

BTW: Is vol smile the same thing as skew?

Thanks

David
 
"Skew" vs "smile" has to do with the shape. As to quantifying the relationship between ATM and OTM vols, that is also a bazillion $ question.
 
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