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.