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pleoni
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Joined: July 13th, 2006, 1:05 pm

What markets make you frown and smile?

August 22nd, 2007, 5:35 pm

I was wondering, under what market conditions will you see a frown in the vol-curve?And moreover, if, let's say that a market has a flat vol curve (like prior to the crash in 96) and you already know that this cannot be true, how can you take advantage of it?Is the skew in the market justified because, on average large downside movements will occur in your book, justifying the higher vol for OTM Puts, or is this something that becomes apparent, even in "normal markets"?I would like to hear your opinion...
 
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Thinker
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Joined: May 2nd, 2007, 2:21 am

What markets make you frown and smile?

August 22nd, 2007, 10:16 pm

My experience is something like this (in Asia).- first off, their is no real "smile" - vols tend to be flat from ATM to 110/120% range - which is where most of the trading is- however, put vols are elevated, so its a half smile- in normal markets supply of structured products (i.e. effectively supply of 80/90% puts) pushes implied vols down BELOW levels justified by realized experience, so the surface is quite flat- in crisis markets of course you suddenly see a lot more buying of puts, pushing up put vols (a lot) to more than justified levelsOther thoughts?
 
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pleoni
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What markets make you frown and smile?

August 23rd, 2007, 10:34 am

Does this imply that e.g. when there is very little demand for OTM puts and calls, that the curve might be a frown, although the distribution contains fat tails?That smells like arbitrage, does it not?
 
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pleoni
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Posts: 134
Joined: July 13th, 2006, 1:05 pm

What markets make you frown and smile?

August 23rd, 2007, 10:34 am

Does this imply that e.g. when there is very little demand for OTM puts and calls, that the curve might be a frown, although the distribution contains fat tails?That smells like arbitrage, does it not?
 
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Martinghoul
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Joined: July 18th, 2006, 5:49 am

What markets make you frown and smile?

August 23rd, 2007, 11:07 am

Pls don't confuse this with arbitrage... The distribution that contains fat tails is based on your historical, backward-looking sample set. Unless you are the Almighty, you do not know what the future distribution looks like (and I do believe the Almighty doesn't do arbitrage). Thus, you can buy OTM options based on your personal VIEW that the mkt is mispricing certain probabilities. Doing this, however, is not arbitrage.For strange smile shape effects you don't have to go further than the recent brouhaha in Sep7 Euro$ contracts. There was some really bizarre stuff going on there that would probably have driven any self-respecting option model totally nuts. You had to see it to believe it... It wasn't a smile or a frown, not even a smirk; a grimace, more likely
 
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Traden4Alpha
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What markets make you frown and smile?

August 23rd, 2007, 11:35 am

Maybe it's an arbitrage opportunity and maybe it's not. If we assume that all participants are risk-neutral, then the smile (or frown) encodes the discrepancy between a Gaussian distribution and the expected distribution of outcomes. A frown suggests an expectation for a platykurtotic distribution of outcomes such as if the market expects prices to stay within a narrow trading range. How can one be sure that the potential for fat tails is equally likely on all maturities?
 
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pleoni
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Joined: July 13th, 2006, 1:05 pm

What markets make you frown and smile?

August 23rd, 2007, 1:06 pm

I agree, this is not arbitrage, sorry for the term. You are right, it is not.But suppose for a matter of reasoning, that the Almighty comes to all quants and says the distribution of the underlying has fat tails, but the options are priced with a frown.How can you take advantage out of it. Is it possible or will it depend on the outcome of the draws from this distribution?
 
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Thinker
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Joined: May 2nd, 2007, 2:21 am

What markets make you frown and smile?

August 23rd, 2007, 10:57 pm

There are too many crabs! So, i think grimace is the right term to describe the smile.I don't view the curve as giving an arbitrage, though, as even if technically they are showing a mis-price (let's say OTM puts overpriced, OTM calls underpriced) there is no liquidity to trade (either a few contracts is all that traded to set the price, or the curve has been extrapolated). So I imagine when determining fair option prices (or vol levels), make sure there are no arbs in the 80/120 space - that's where the real trading is likely to take place
 
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Martinghoul
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What markets make you frown and smile?

August 28th, 2007, 9:03 am

Pleoni, if the Almighty imparted this secret to you, you're all set... In a situation that you describe (i.e. you know the distribution has fat tails, but the mkt is effectively mis-pricing it) you should be buying outstrikes like there's no tomorrow. Clearly, if we go with your assumption, around expiry the distribution that gets realized is the one you, but not the mkt, expected, so you make money. Things to take into account are the usual issues of trade mtm vs pnl at expiry, i.e. you could be wrong all the way there and even get stopped out, in spite of possibly being right at expiry. To quote a famous dictum "mkts can remain irrational longer than you can remain solvent".Again, Sep Euro$ (similar for Sep Sht Stg, for that matter) is the best example that I can point to, even though the situation was the opposite. Because of all the LIBOR issues, on the one hand, and the way people were expecting the Fed to act, the mkt was pricing in insanely fat tails. Any model would have suggested that outstrikes were massively overpriced. However, selling them proved hazardous to many people's professional health, as they went even more insanely bid, when people scrambled to cover their exposure to various improbable scenarios. Selling an option is, of course, different to buying one, but you get the idea.So arbitrage it ain't, but rather a view on either the implied or realized distribution (depends on the horizon).
Last edited by Martinghoul on August 27th, 2007, 10:00 pm, edited 1 time in total.