Journal of Risk

Risk.net

Pricing and hedging options with rollover parameters

Sol Kim

  • The simple trader rules dominate mathematically more sophisticated models.
  • The new rollover strategy, the next-to-next strategy, can decrease the pricing and hedging errors of all options pricing models compared to the nearest-to-next approach. 
  • The “absolute smile” trader rule that assumes that the implied volatility follows a fixed function of the strike price has the advantage of simplicity and is the best model for pricing and hedging options.
     

We implement a “horse race” competition between several option-pricing models for Standard & Poor’s 500 options. We consider trader rules (the so-called ad hoc Black–Scholes model) to predict future implied volatilities by applying simple ad hoc rules, as well as mathematically complicated option-pricing models, to the observed current implied volatility patterns. The traditional rollover strategy, ie, the nearest-to-next approach, and a new rollover strategy, the next-to-next approach, are also compared for the parameters of each option-pricing model. We find that simple trader rules dominate mathematically more sophisticated models, and that the next-to-next strategy can decrease the pricing and hedging errors of all option-pricing models, unlike the nearest-to-next approach. The “absolute smile” trader rule, which assumes that the implied volatility follows a fixed function of the strike price, has the advantage of simplicity and is the best model for pricing and hedging options.

To continue reading...

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here: