Factoring in Sudden Volatility

comfortablesofa · July 14th, 2006, 7:07 pm

How can you factor in sudden spikes in volatility (such as the non-far payroll release for the eur/usd) into option pricing? Technically, I could rip the shirts off every market maker who is not factoring the incomming burst in volatility by purchasing either an exotic option or straddling vannilas of the underlying (provided the option gets executed the way i want ... like the way it keep getting executed on retail Forex Options Platforms

).

untwigged · July 14th, 2006, 10:48 pm

Surely the spike (if expected) will just increase the implied vol for every option that expires after the event date?

comfortablesofa · July 19th, 2006, 6:12 pm

I was thinking of that too - but for some reason, the idea of implied volatility spiking didn't seem correct. For the example mentioned, I know for a fact that dealers on the interbank market don't bother with writing options with something as gregarious as an expected NFP.One of the dealers I spoke with spoke of something called a "Chaos Chart" which almost quantifies these types of risks. I'm having a difficult time believing that exists if we are still having arbitrage opportunities in our markets.

Flare1 · July 19th, 2006, 6:36 pm

I agree with untwigged, it would just increase your vols across whatever option months your "spike" relates to. I don't really see the point of this unless the spike occurs on the same day you're valuing/reporting option values. If a spike occurs in the middle of the month and then flattens back out before the end of the month, do you care?

comfortablesofa · July 19th, 2006, 6:47 pm

Well - sure the spike matters - if there's something as obvious as a spike, it reveals arbitrage opportunities.In regards to specifications of the option - consider the trade in question to be shorting double barrier single touch options.