Combining American and European Options in a Volatility Surface
Summary
The discussion considers how to build an equity volatility surface when American and European options are listed on the same underlying and provide separate implied volatility observations at each maturity. One practical preference is to use European options when their liquidity is comparable, because their prices map more directly to standard European-option surface methods. American options that are likely to be exercised early may provide limited information about the distant part of the volatility surface, making their implied volatilities harder to interpret.
Another approach is to de-Americanize American option prices and then fit the resulting European-equivalent inputs. This requires reliable market data, careful treatment of bid-ask spreads and stale quotes, and sound forward estimates, often informed by put-call parity. Timing mismatches between underlying and option markets, sparse or one-sided quotes, and dividend seasonality complicate the process. If the surface is intended to price or risk-manage the same American options being traded, calibration should account for their American exercise feature. No single construction method is shown to work for every market or purpose.
Key ideas
- European option prices are often simpler inputs for standard volatility surface construction.
- Early exercise can make American option implied volatilities less informative for some surface regions.
- De-Americanizing prices is one route to European-equivalent surface inputs.
- Input filtering, forward estimation, market timing, and dividends can materially affect calibration.
- A surface used to price American options should reflect their exercise feature.
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Full text
# Different Exercise Style Options on Same Underlying # Different Exercise Style Options on Same Underlying Some equities on European markets have options traded in two different exercise styles: American and European. Examples: - ABB and ABB (european) on Eurex - Banco Santander on MEFF Consider constructing volatility surface for given equity with two set of options, when for each expiration/maturity there are two corresponding IV points (from European and American options respectively.) How one in this case would construct the surface and what is the reasoning? - Using only one set of options (either European or American), chosen by some parameter (total volume, open interest, etc.) - Combining both sets - Something else ## Answer by Brian B (score 3, accepted) https://quant.stackexchange.com/a/8075 If you can get anywhere close to the same open-interest and volume using European options as the corresponding American ones, you'll have a much easier time just using them. American options with high probability of early exercise don't contain information about that back end of the vol surface, and it's kind of hard to decide just what to do with their implied vols. The only way you can be sure you've done it properly is to throw them all into some giant multivariate optimization algorithm on a parameterized volatility surface. That said, if you're calibrating the vol surface to trade these same American options, rather than (say) to fit some exotics-pricing or risk model, then you had better calibrate to those American options. ## Answer by AKdemy (score 1) https://quant.stackexchange.com/a/63556 Frequently, American options are de-Americanized. Afterward, you "simply" use the standard model you use to construct your VOL surface based on European prices. In reality, things are quite messy though: - You need data filtering to ensure the reliability of the inputs (do you use several exchanges vs most liquid, stale prices, unreliable bid-ask spreads, spikes, jumps around market open / close...) - Theoretically, it's easy to construct forwards from put-call parity (apart from options you could also use futures; but the maturities usually do not align, dividend futures, OTC instruments, etc). Practically, you face numerous problems though (the underlying and options may trade at different times, listed option prices can be fairly unreliable in some cases, or only one-sided markets, etc.). - Dividend seasonality is an issue...
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