Wednesday, November 20th 2019
Is It Best To Value Your Options Using Mid-Point?
To determine a reasonable valuation to your options position, using a theoretical value is best, especially in thinly traded securities, where the bid-ask is wide.
Valuing options positions using the mid-point between the bid and ask can be misleading, especially for thinly traded options. A theoretical value based on a smart smoothing process of the implied volatility is far better. ORATS uses a smoothing process called Smooth Market Values (SMV) to estimate implied volatility for an expiration or the entire options chain. The SMV process provides reasonable valuations that are proximate to historical implied and historical volatility.
No, valuing your options positions using the mid-point between the bid and ask can be misleading. Especially for thinly traded options you should use a theoretical value.
What about using the last trade?
The last trade of an option could have been days away when the stock price was much different.
Bid-ask quotes are often very wide and meaningless.
A theoretical value based on a smart smoothing process of the implied volatility is far better than the other two methods.
At ORATS, we have smoothing that uses historical processes if we score the market quality poorly. This means we use the last minimally acceptable market to get an estimate of implied volatility for and expiration or the entire options chain.
For example, I looked for a low scoring stock and found ABBV.
Let say you were long the Dec 5 calls and short Dec 7 calls.
- The theoretical value of that spread is $0.02
- The mid value is $0.00
- The last value is $0.05 (not shown, Dec 5=0.05, Dec 7 0.00 with no last)
For theoretical volatility, our summarization process is called Smooth Market Values (SMV) and the smvVol column above is the result. For the Dec 5 the theo vol is 0.388 and 0.389 for the 7s. For reasonableness check the history of the implied volatility and the historical volatility of the stock ex-earnings as in the graph below, the IV has been around 32% and the HV around 30%:
Given the theo volatilities proximity to historical IV and HV, you can have some confidence that the theo valuations are reasonable.
Options pricing models produce theoretical values for options and implied volatilities. Here we show common methods for calculating IV and how to interpret them.
Implied volatility, contango, and forward volatility can be used to predict underlying movement. Ex-earnings IV for stocks is explained. Backwardation is described as is the flat volatility method.