Adjusting Volatility Surfaces for Option Margins and Hedging Liquidity

Summary

The post asks how a trader should adjust a volatility surface when pricing a product that includes a long option. The answer describes shifting the parameters of a chosen surface model in absolute terms, with adjustments reflecting the trader’s exposure to different risks. A position can, for example, involve buying volatility while selling skew, so a single uniform adjustment to the whole surface may not represent the risk profile.

The suggested adjustments depend on the liquidity of the listed market used to hedge the exposure, rather than following a fixed schedule based only on the level of implied volatility. The answer also notes that pricing may be brought closer to mid-market when the trade reduces existing book risk or is otherwise desirable to the trader. These are qualitative guidelines, not a calibrated margin method: the post gives no parameter calibration, liquidity measure, or evidence that a particular shift is suitable across markets or products.

Key ideas

• A volatility margin can be represented by absolute shifts to parameters of the chosen surface model.
• Parameter adjustments should reflect the specific volatility and skew exposures in the trade.
• Hedge-market liquidity is presented as a key driver of the shifts.
• Risk reduction to the existing book can affect how close to mid-market a trade is priced.
• The post gives qualitative guidance without a calibration procedure or market-specific evidence.

Tags

# Options volatility margin


# Options volatility margin












A basic question.

When traders structure a product in which they are long an option, how is the volatility surface shifted to take into account a margin ?

Is it a multiplicative coefficient, say 95% of the initial surface level ?

Is it

- if 10 < vol < 20, shift 1 point

- if 20 < vol < 30, shift 2 points

- and so on

Is it something else ?

## Answer by hjw (score 0, accepted)

https://quant.stackexchange.com/a/40839

Vol surface is parameterized and u shift each parameter in absolute value depending on your exposure. (u can be buying vol but selling skew) e.g alpha + 1, beta - 2 whatever alpha and beta stands for in your model. However shifts depend usually on the liquidity of the listed market in which you need to hedge rather than the vol level. If trade is risk reducing to the book/you like the position, its not uncommon to price at mid to try to win the deal

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.