Part of the confusion could come about because the described MM (or specialist) process stops too early. For an initial guess, the market makers probably do guess but it is what they do afterward in price discovery mode that causes fluctuations. The game of the market maker is not to speculate but to balance out and he uses price to do that. Is that wrong? Make book= book maker = bookie. They all do the same thing after the initial odds setting. They have a definite edge. We have to overcome that. The introduction of liquidity concerns completely changes things and that was my tip off that SLE is no beginner. Options price risk by price discovery don't they?
Well, it obviously doesn't depend on the strike price. However, why not make an assumption that there's a relationship between future volatility and the underlying, as I suggested? For example, in the world of rates, one of the properties of skew is that vol for options whose strikes are close to zero is, most of the time, lower than it would be otherwise (there are obviously sophisticated functional forms that describe these sorts of relationships, but you can think of volatility being "absorbed" or "dampened" by the zero bound that, most of the time, applies to nominal interest rates). My point is that, in the case I described, different vols at different strikes describe expected future volatility, but it's expectation that's conditional on the expected price of the underlying. Given that there's a multitude of future prices of the underlying, there may be a multitude of future expected volatilities. As to your other question, that's why there are models (of which BS is but one), innit? For options whose prices cannot be directly observed in the mkt, you can try to "deduce" the distribution of "future expected volatilities" in different states of the mkt and then it's just a matter of calculating the expected value. This "deduction" can be as simplistic or as sophisticated as you like. So all I'm saying is that if vol itself is a stochastic process, there's, by definition, not only a multitude of possible expected future prices of the underlying, but also a multitude of possible expected future volatilities for each price of the underlying. BTW, I am not 100% sure that this is what sle has been trying to convey.
Yes, of course. Implied volatility is a characteristic of an option that has a one-to-one relationship with a particular price. However, while the price of an option is not a particularly useful measure, IV allows you to perform some analysis. At the very least, it allows you to compare two different options and draw all sorts of potentially useful conclusions. It also allows you to assess a given option in a historical context, which obviously would be impossible to do with a price. For example, in FX people look at risk reversals. If all you had were historical time series of relevant option prices, you would have a really hard time assessing the current mkt pricing of a risk reversal in a historical context. If you have time series of vols for the right options, it's a whole new ballgame. I think of the relationship between prices and vols for options as being similar to the relationship between prices and yields for bonds. I dunno about any secret indicator formulas. But aren't most "indicators", esp the TA ones, based on price and price alone? Well, there's a whole variety of ways to do it. I think there's a couple of threads that discuss some examples. I can certainly discuss how I use it, but it might not help, given that I work with a different asset class.
Stardust 9182: "options price risk by price discovery" Yes Each buyer and seller validates the posted bid/ask by acting. IV is kind of like a market within the option market, a subset. The remaining greeks are derived. "the bookies have an edge" Well characterized. I overcome this by using time in my favor, as a seller.
Well, rather simple - if you think implied vol [over/under]-predicts the future realized, [sell/buy] the option and delta-hedge. If you manage to find some options that are over-predicting and some that are under-predicting, you can run a nice, beta-neutral book. The real question is - how do you discover that the current implied is rich or cheap?
Your strategy and edge must come from you. It has to be created by you. In my case, my trading system is an expression of how I think. I did not study advanced math or finance, I studied architecture. I was taught to look at design problems as a process. The process being informed by the questions asked and, by how the questions were phrased. Phrasing the question properly was an important step as was thinking multidimensionally over time among many other things. Each trader brings their life experience and thought process to the screen every day. There is room in the markets for countless strategies. Create one that is an extension of you. Developing a strategy requires time and experience. You have to marinate in the options markets and their underlying to see this. I started in June 1995 and still have much to learn. I found a breakthrough 2 1/2 years ago and realize now it was wort the time and effort(I took a break for a few years after the 2000 downturn). Liquid options are more or less fairly priced. It is not so much their pricing that matters as is what you do with them and to them. Remember, Black Scholes is limited. It is an accommodation. Think outside the box. Good luck