Fitting Volatility Surfaces to Bid, Ask, and Mid Quotes

Summary

The document raises a practical calibration problem: fitting an SVI or SABR volatility surface to mid implied volatility produced a satisfactory fit, while separate fits to bid or ask implied volatility performed poorly. It asks how to fit surfaces to executable quotes and how traders use a surface calibrated to mid prices, especially when the options are relatively illiquid.

It offers no answer, calibration method, evidence, or trading rule. Its useful focus is the distinction between a statistical fit to a representative quote and the prices available for execution. Bid and ask observations can vary across strikes and may be noisy in illiquid options, so the best-fitting surface need not coincide with either side of the market. The document leaves open how to handle quote quality, weighting, and market decisions; it should be read as a statement of the problem rather than a source of established best practices.

Key ideas

• Mid, bid, and ask implied volatilities can lead to very different surface calibration quality.
• Illiquid option quotes complicate the interpretation and fitting of bid and ask observations.
• The document asks how traders use mid-calibrated surfaces when deciding whether to trade at executable prices.
• No calibration procedure or empirical conclusion is supplied.

Tags

# Volatility Surface Construction: Ask IV, Bid IV and Mid IV


# Volatility Surface Construction: Ask IV, Bid IV and Mid IV












I am presently engaged in a project wherein my objective is to construct a volatility surface utilizing either the SVI parameterization or the SABR model, leveraging real market data. Initially, I used mid/mark implied volatility for the purpose of calibration, yielding relatively satisfactory fit. However, my calibration attempts using ask_iv or bid_iv have yielded very bad fits.

I find myself in a state of uncertainty as to the underlying reasons for these subpar calibrations when utilizing ask or bid implied volatility. Logically, it stands to reason that individuals engaged in trading activities would typically reference either ask or bid implied volatility when executing their orders. Consequently, I am curious if there exist specific guidelines or best practices that one should adhere to when fitting the volatility surface with ask/bid_iv data. Furthermore, I am interested in understanding how market participants make trading decisions based on a volatility surface calibrated using mid/mark_iv. It's pertinent to mention that the options I am dealing with are relatively illiquid.

I would greatly appreciate any references to books, research papers, blogs, or any resources that delve into this subject matter, as they would prove invaluable to my project.

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.