Just kidding. There is no model that works all the time. It is about the law of big numbers. Take ten BS models, plug in the same parameters, ten results. It is about the implementation. Not a plug in model, scans for a criteria with valuation being a small part ...
Supply/demand of an option and therefore its price are determined by sellers and buyers' assessment of the underlying volatility during the period from current time till expiration day. MMs are merely facilitating their transactions. With war and corp. scandals over, and the earnings have been mostly inline with expectations lately, I can see why the volatility in the equity market is low. Though I expect it will go higher when we have a correction or even a crash. Interestingly the CBOT 10-Year Note option's IV is over 13% today. It was only two weeks ago when the IV was below 8%, a 62% increase. Talking about the volatility of volatility, the stuff the GARCH models try to deal with. Again this high IV is not "set" by MMs, rather it's those big banks. Their opinions on the future interest rate movement "set" the price of the option price and therefore the IV. For short term options, its premium and Greeks are not sensitive to the risk free interest rate. I used 1% for convenience. 2% won't make much difference.
The rates vol curve has significantly flattened over the past few days, increasing at the long end and decreasing on the short end. On the other hand, the rates have steepened even more - and I know a whole bunch of people that got screwed this week.
That's fine. But if the models are saying that pricing the options outside where they are priced "correctly" whether there is a supply/demand issue doesn't change the mathematics and probabilities. I would think they are only going to make a market where they have the odds on their side, and the "only" way to know that is with the models? Otherwise, why use them at all? Either a) they are underpriced, b) priced correctly, or c) overpriced. In the two cases where they are over/under priced, judged by comparison with the pricing given by BS, I would love to know why that model these guys are using to make markets allows them to ("mis")price an option by 50% of what the BS gives? If you told me, "they take BS and then use VIX to further tune the spread of the market they are making," at least that would make sense... Huh? Of the 500 companies in the SP500 that have reported, more than 2/3 of them beat expectation, though looking forward they are once again catious of future earnings. Ok. BTW, I noticed that one of the inputs to SABR is volvol. Thanks. I noticed that by playing around with the interest rate and noticing the little change in the option price. It was more of an academic question... nitro
Ok, I figured it out. Looks like the volatility they are using is some sort of calculation based on more recent values than I was using. When I use an ABS Vol of ~33.00%, my numbers look almost identical to theirs. Looks like http://www.ivolatility.com has "better" vol numbers... nitro
It is always all about the vol. If there was one correct answer, then why do 5 exchanges have different prices ...