Constructing Implied Volatility Slices from American Options

Summary

The document describes difficulties in deriving pseudo-European implied volatility slices from American option prices through de-Americanization. The method may produce different European implied volatilities at the same strike when both calls and puts are available. A common construction mentioned is to use out-of-the-money options, with a cited study also examining puts alone.

The questioner notes that under high dividends and interest rates, an out-of-the-money-only approach may produce inconsistent prices for in-the-money American options. Separate put and call slices are raised as one possible response. The document asks what established practices handle liquid calls and puts, how to construct a robust slice in difficult market conditions, and whether fitting a model that prices American options directly could then yield a pseudo-European slice. It presents these as open questions, without an answer, method comparison, or evidence favoring one approach.

Key ideas

• De-Americanization can yield different European implied volatilities for calls and puts at the same strike.
• Using out-of-the-money options is a common approach to constructing an implied volatility slice.
• High dividends and rates may create inconsistent in-the-money American option prices under that approach.
• Separate put and call slices or direct American option model fitting are proposed as questions, not established recommendations.
• The document supplies no comparative evidence about which construction method is best.

Tags

# De-Americanization and Implied Volatility Slice, american options: Best Practices?


# De-Americanization and Implied Volatility Slice, american options: Best Practices?












I’ve been exploring the challenges associated with the de-Americanization method for creating implied volatility (IV) slices from American options.

One key issue is that this method can result in different European IV values for the same strike. The question is, which iv to use?

A common approach is to use only out-of-the-money (OTM) options to construct the volatility slice, as discussed in the paper "Calibration to American options: Numerical investigation of the de-Americanization method" (they also tried puts only) and in this previous post.

However, under conditions of high dividends and rates, this approach can lead to inconsistent pricing for in-the-money (ITM) American options. Several discussions, such as this one, suggest using two separate slices can be a possibility: one for puts and another for calls.

My Questions:

- What is the common practices to address the de-Americanization issue when there are two implied volatilities (IVs) for the same strike, given that both the call and put are liquid?

- What are the established methods for constructing a pseudo-European IV slice from American options, especially under challenging conditions like high dividends and rates?

- To avoid the issue of multiple IV slices, is it better to directly fit a model that correctly prices both ITM and OTM american options at the same strike, and then use that model to derive a pseudo-European IV slice?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

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