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Jericho
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Posts: 25
Joined: August 22nd, 2007, 3:14 pm

Deep ITM and OTM options

March 30th, 2022, 8:54 am

I have a question on pricing of Deep ITM and Deep OTM options where we know liquidity is likely to be sparse
 
Generally, our policy (working on the Valuations desk) is to mark to last price if between bid/ask and mid otherwise. This works well generally when the bid/ask markets are being updated with real levels, but we do see cases where the bid/ask is very wide, and the farther in- or out- of the money it gets the worse this issue can be. As far as pnl impact the far ITM impact is potentially larger.
 
Conceptually,  ITM options will be close to the intrinsic value, so a conceptually simple test would be to compare default price (i.e. last or mid according to the rule) to the intrinsic value:
 
If abs(Intrinsic MV – default MV) > threshold then go to theoretical price
 

In thinking about how to implement, though, it gets complicated:
 
If option delta > delta threshold (to test for far ITM options)
                Calculate intrinsic value
                If abs(intrinsic value – default value) > impact threshold
                                Calculate modeled price (in Bloomberg?)
                                If abs(modeled price – default value) > impact threshold
                                                Use modeled price else retain default value
 
Can anyone think of a simpler way? It may be worth it to implement something like this, as it does seem to capture the economics better, but it seems like it will require some time to put together - im sure there must be a simpler solution?

Also how would you catageorise a deep ITM or deep OTM option?  By having a hard delta value?  so if Delta is greater than 0.9 then deep ITM and less than 0.1 then deep OTM?

Any guidance is fully appreciated

Thanks

J.
 
 
Mercadian
Posts: 39
Joined: July 24th, 2020, 4:22 pm

Re: Deep ITM and OTM options

March 30th, 2022, 5:23 pm

Hey Jericho,

What asset class are you looking at? is it FX (Delta reference)? also what types of options? Listed/OTC Vanillas?

Rgds,
M
 
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Jericho
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Posts: 25
Joined: August 22nd, 2007, 3:14 pm

Re: Deep ITM and OTM options

March 30th, 2022, 6:15 pm

Hey its listed options mainly on equity/equity indices underliers so Listed options on NKY for example 

thanks for the help i appreciate it
 
Mercadian
Posts: 39
Joined: July 24th, 2020, 4:22 pm

Re: Deep ITM and OTM options

March 30th, 2022, 7:20 pm

Hi Jericho, 

Thanks for the answers, good to know.

Just paraphrasing your logic to make sure we're on the same page:

If Deep ITM/OTM? = Yes
  compute Intrinsic value
   If Value Threshold is broken? = Yes
     compute Theoretical Price
      If Price Threshold is broken? = Yes
       return Theoretical price

I honestly think its not that complex and should be easy/fast to implement, not sure about having both a Price and Value Threshold seem like versions of the same thing to me and maybe you end up having to ensure consistency across them which might be extra work.

Another point I would make is that in the listed world you should get an official closing/settlement price from the exchange, do you not? so I guess you might need to think about the regulation in terms of marking to market.

Regarding the Deep ITM/OTM classification indeed you can simply use a delta or moneyness fixed boundary like 10 and 90, maybe try different types of moneyness, think about delta calls/puts.

One other thing to consider is how your colleagues in other desks might be looking at the same volatility points for those underlyings to ensure consistency firmwide, e.g. they might be using heston to calibrate the smile in order to price OTC products like Volswaps so it might be worth considering the theoretical vol/price in that same light.

rgds,

M
 
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Jericho
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Posts: 25
Joined: August 22nd, 2007, 3:14 pm

Re: Deep ITM and OTM options

April 3rd, 2022, 10:15 am

Thanks Mercadian, I appreciate your time on this (and the other questions) - I think I have enough to get going on this

Regards
 
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Jericho
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Posts: 25
Joined: August 22nd, 2007, 3:14 pm

Re: Deep ITM and OTM options

August 18th, 2022, 3:48 pm

Hey just wanted to touch on this again - How could one test if a Bid/Ask spread is "bad" - by "bad" I mean:
Either the Bid or Ask is zero
a Fat fingered Bid or Ask (which means the spread is huge)
The Bid is higher than the Ask

IS there a formulaic I could use or is it simply a case of testing the above holds one by one?  Im thinking some kind of generic formula to satisfy that my bid/ask for a given security for a given date/time is reasonable

Any ideas/thoughts please let me know
J.
 
Mercadian
Posts: 39
Joined: July 24th, 2020, 4:22 pm

Re: Deep ITM and OTM options

August 24th, 2022, 4:55 pm

Hey Jericho,

This might be a naïve answer but what I would do is something like the below:

- Ask>(Ask-Bid)>0 ---> here you check Ask>Bid, Ask<>0 and Bid <>0.
- Amplitude Threshold > Ask/Bid >1 ---> here you check Ask>Bid, Ask<>0 and Bid <>0 and that the Bid/Ask spread is "reasonable" to a threshold

Regards,
M